Stranger Things

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The Netflix mini-series Stranger Things has nothing on reality. To recap the year so far, we are battling through a global pandemic unlike any in the past 100 years. The novel coronavirus is highly contagious and extremely dangerous, particularly to the elderly, those with pre-existing health conditions, and those without easy access to our healthcare system. To counter this deadly virus, all fifty states issued some form of stay-at-home order creating a self-induced economic coma. In just the past quarter, we’ve seen negative oil prices (see Free Oil, by Michael Molitor on our website), an increase in the number of countries issuing debt with negative interest rates, massive anti-racist protests throughout the country including one in which a six square block section of a city was taken over by protestors, hand-to-hand combat on the border between China and India, and North Korea antagonizing South Korea by blowing up a building. Also in the category of “strange,” Hertz, a company in bankruptcy, rallied 400%, and then decided to try to issue new stock because of the rally. To be fair, its disclosure statement did say it is highly likely this new equity would be worthless (caveat emptor to the extreme). The stock market responded to all this news by rebounding with a vengeance. The most common question we have received over the last couple of months is, “How is that possible given all of the uncertainties (and oddities) we’re facing today?”

The very short, simplified answer is the shear financial power of our government. The speed with which the pandemic hit our markets was matched by the speed with which our government responded (as shocking as that might sound). Congress passed numerous stimulus bills costing several trillion dollars and the Federal Reserve pumped in several trillion dollars more. It used every trick ever learned from past financial crises and added a few new ones. The dollar amount of the stimulus projected through the end of the year will end up totaling approximately 20% of our nation’s Gross Domestic Product (GDP), a staggering amount with most of that money literally created out of thin air.

This aided the stock market on several fronts. First, this money went directly to those most affected by the pandemic. Unlike during the Great Recession when the stimulus money went through the banking system, this money went directly to taxpayers and business owners with the goal of keeping wage earners afloat. The government incentivized business owners to hold onto their employees. Despite this, there were massive layoffs and furloughs as the economy came to a screeching halt. The government also approved more unemployment benefits (with a bonus $600/week) than in past recessions. 75% of those who applied received benefits. Normally, only about 25% get them. This allowed most people to continue to pay their bills and minimized damage to businesses (companies in the stock market).

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One other possible reason for the surprising rebound during a pandemic is a bit more troublesome. Schwab reported that during the first quarter, they opened a record 609,000 new retail client accounts. Relative newcomer, Robinhood, signed over 3 million new clients. The combination of no commissions, a stimulus check, no sports to bet on, and a lot of free time has perhaps contributed to a retail investor boom in the stock market. The total effect of this is difficult to gauge, but the Hertz example mentioned above highlights why this might be dangerous if this is indeed a major contributor to the rally. Contacts in the brokerage industry have mentioned that a lot of these accounts are starting with $1,200 or $2,400 values, the exact amount of the stimulus checks received early in the quarter.

 

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Secondly, the Fed provided a great deal of liquidity to markets that were not functioning well during the initial panic from the first quarter. They propped up prices by buying the bonds of companies. This kept companies’ borrowing costs down and prevented marketplace panic forcing unnecessary bankruptcies. Thirdly, the Fed cut interest rates on short-term bonds to near zero. Long-term bonds followed suit with the 30-year bond dropping below 1% at one point. This has an indirect effect on the stock market. Treasury bonds represent the risk-free investment option. When the expected rate of return drops to essentially nothing, investors look elsewhere. Many of those dollars flowed back into the stock market, thus forming some semblance of equilibrium between these two markets.

So now what? An extremely wide range of possible outcomes exists for the next 18 months. We use scenario analysis to help us position portfolios in times like these. As you might expect, the progression of the virus and our government’s response to it will drive all these scenarios. Our base case suggests the virus will not be under control until a vaccine comes out. The fastest this could happen, with enough of us vaccinated to have a meaningful effect, is some time in mid- to late 2021. Past experience with pandemics predicts a second wave is highly likely by the end of this year. We are already seeing cases rise now that most states have reopened to some degree. What will happen in the fall when children possibly return to school and colder temperatures drive people indoors?

In this base case, our economy stays in recession, or at best a near zero-growth environment for a couple of years. Earnings don’t top 2019 levels until at least 2022. Many companies with high debt levels and a high dependence on travel or hospitality will fail. Stay-at-home workers discover they do not need to go to the office as often, and this becomes a more permanent part of how our economy functions. This affects commercial buildings negatively but does have some positive side effects (lower pollution, more efficient workspaces, etc.). Our government will continue to add stimulus to the economy in an effort to keep things from completely unraveling.

A more positive scenario would involve new therapeutics coming to market. While this wouldn’t end the pandemic, it may allow more people to feel safe enough to venture back out to restaurants and travel. We have already seen improvements in patient care and outcomes, but the risk of death is still too high – especially for the most vulnerable groups. If this risk could be diminished down to a level similar to that of the flu, the worst would be behind us.

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A more negative scenario develops if the vaccines prove ineffective or dangerous. There are over 150 trials right now. We have attacked this challenge with all that modern science has to offer. This makes this scenario somewhat remote, but not impossible. This scenario would cause a great deal of financial setbacks and a prolonged recession as governments do not have an endless supply of resources.

In consideration of all of these possible scenarios, we have positioned portfolios with a higher cash balance, more gold, fewer cyclically sensitive stocks, more growth names somewhat insulated from the effects of another quarantine, and a few stronger value names that would perform well if a positive scenario develops. As the United States seems to be an epicenter of the virus, we have continued to add to our international exposure. At some point, it will make sense to add some of the riskier, badly beaten down stocks to the portfolio. Now is a bit early to implement this tactic.

Survival is paramount in this moment. This is true of your portfolio, but of even more importance is your health. Please take care of yourself and your loved ones and follow the CDC guidelines: wear a mask in public, stay six feet apart from others, and remain home as much as possible. As we try to do with your portfolio…avoid unnecessary risks. One long-time client succumbed to this disease; we grieve along with her family. Know that you are all in our thoughts and prayers during this very difficult time.

Sincerely,

Anthony J. DiGiovanni, CFA

Free Oil

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Headlines from news sources across the financial industry rushed to proclaim “Oil Trading at Negative Prices” yesterday as the May contract for WTI (West Texas Intermediate) Crude Oil traded in negative territory.  How can oil, a commodity with versatile uses, trade at negative prices?  Would a company really pay to have its product taken away?  It’s complicated.

The oil market is large and only one small part of it went negative.  Oil commodities consist of the spot market (current market prices) and the futures market (prices for a future date).  Yesterday’s negative price was only in the futures market.  There are two main types of oil:  WTI and Brent Crude.  Only WTI went negative.  Finally, futures extend far into the future.  Only the May 2020 contract went negative.  Let’s take a closer look at why.

A futures contract is a legally binding contract between a buyer and a seller to transact at an agreed upon price on a set date.  A buyer who still owns a contract at the expiration date (which was yesterday for the May contract) is contractually obligated to buy the oil at the agreed price and take delivery of it.  A buyer who does not do so is in default of the contract; the seller of the oil can sue.

In the futures market, most traders unwind their positions (sell if previously bought and buy if previously sold) prior to expiration because most participants don’t have the ability to take physical possession of large numbers of barrels of oil. Usually though, there are some oil companies who can take delivery and will buy if the price gets too low.  That did not happen yesterday.  With few people flying or driving, oil reserves are full.  Nobody had the capacity to take the physical oil, so traders were forced to close out their positions at any price, even a negative price to avoid defaulting.  It’s kind of like having an estate sale when moving.  It would be better to get $100 for your dining room table, but if no buyer comes along, it still needs to go, and you might end up paying someone $50 to take it away.

How did this happen?  In a properly functioning market, oil prices should not be negative because oil has use not only as a fuel but also as a key ingredient for countless products.  There are two main types of crude prices: WTI and Brent Crude.  Brent represents more of a worldwide price of crude since it is produced near a seaport and can be easily distributed globally.  WTI is a landlocked crude, produced in the middle of America, and can only be delivered to Cushing, Oklahoma.  Buyers of WTI must take possession of it in Cushing and then either store it or have a way to immediately ship it.  This is where the breakdown occurred.

Financial markets are constantly rebalancing themselves and engaging in price discovery.  When prices get too high, people sell, and the increased selling brings the price back to equilibrium.  The same process happens in reverse when prices fall deeply below the economic value; buyers step in and bring the price back to its proper value.  But when WTI prices fell yesterday, buyers did not step in.  It seems like it would have been a perfect opportunity to make a significant amount of money by buying at negative prices and selling the next month at positive prices.  However, to restate the key points, futures contracts are legally binding and delivery must be taken in Cushing, Oklahoma.  If there is no available storage in the area, and no transport system in place, then nobody can buy.  If nobody is buying, the sellers become desperate even to such a degree that they are willing to pay others to take the contract off their hands.  That is what we saw yesterday in the May WTI Crude futures.

The other type of oil, Brent Crude, is still trading in the $20 range, and even WTI Crude futures for June is still $15 per barrel.  The price for future WTI one year out is in the $30 range (see chart below).  So, the negative price was an aberration in the current contract that expired with too many sellers and not enough storage capacity for the buyers.  We joked about buying some oil yesterday and storing it at our vacant White Pine offices.  Unfortunately, we couldn’t figure out how to transport the 1,000 barrels one futures contract represents up to our offices, and we’re not sure all the barrels would fit.

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Last month, Russia and Saudi Arabia indicated there would be no slowdown in oil production, thus exacerbating the excess supply caused by the coronavirus pandemic halting the great majority of air travel, automobile use, cruise trips, and other economic activities that typically use oil.  As always happens with a large supply and a dearth of demand, prices dropped.  It is unlikely the world-wide Brent Crude price will go negative as there are still some places in the world to store the excess supply.  However, if demand doesn’t pick up soon, it is possible we will see a repeat of this issue when the June futures contract expires.

 

While the impact to the overall equity market is minimal, this event does provide some insight into the health of the global economy.  Oil prices and the economy often go hand in hand as oil is one of the main fuels used to generate energy.  The low prices indicate the severe lack of demand both in the US and the world.  This unusual phenomenon is a symptom of the severe disruptions we are all feeling in our daily lives.  The futures curve may indicate how long the market thinks this lack of demand will last and when the economy can begin to return to normal; the graph indicates the price of oil returns to a more typical $30 price by the end of the year.  We will continue to monitor this situation and how it affects our positions.  Meanwhile, we’ll work on reconfiguring our desks to accommodate 1,000 barrels of oil.

Investing in a Difficult Environment

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Major stock market indexes across the globe fell over 10% this week.  It has been a long time since we have seen such extreme volatility.  This type of occurrence often results in undesirable emotions:  fear, anxiety, distress, perhaps even anger.  Our natural instinct is to flee danger.  When it comes to investing, these emotions and instinct work against our best interests.  During times like these, it is wise to take a step back and calmly assess the situation.

 

The major new development that ignited this sell-off is the spread of the coronavirus to Italy, Iran, and South Korea.  The hope of containment vanished with this news.  Unfortunately, it appears we have a real pandemic on our hands, and history offers limited help in analyzing the situation.  SARS was a similar virus in that it started with a transfer from animals to humans in Asia.  SARS, however, did not spread easily, and only 8,000 people were ultimately affected by it, with 10% (or 800 people) dying from it.  COVID-19, the official name of the coronavirus we’re dealing with today, has already infected ten times as many people.  Fortunately, for now anyway, it appears its death rate (3%) is significantly lower than that of SARS.

The last pandemic that spread as quickly as COVID-19 was the Spanish Flu of 1918.  Comparisons to this period are extremely difficult.  According to the Center for Disease Control (CDC), the Spanish Flu infected 500 million people, or roughly 1/3 of the world’s population at that time.  The death rate was similar to that of SARS as an estimated 50 million (or 10%) of those infected perished.  However, our understanding of science has greatly advanced since that time.  We have already sequenced the DNA of this virus and are working on vaccines, a concept that would have been completely foreign to anyone living in 1918.  Still, inventing an effective vaccine and then manufacturing enough quantities in time seems unlikely.  While we may not create a vaccine or antiviral drug fast enough to prevent the spread of the disease, we do have antibiotics now that can help prevent deaths from secondary infections.

 

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Markets do not like uncertainty, and this virus is providing large quantities of it.  Reading the CDC website to learn more about the virus provides few clues as to how this will play out.  They just don’t know what will happen.  Will the virus die off in the summer like most other viruses?  SARS ended in July with the warmer weather.  We don’t know if this virus will act the same way.  Even if it does, will it resurface in the fall as the Spanish Flu did?  Will we have a vaccine or other medicines to combat it by then?  We don’t know.  Will it spread widely in the US?  We don’t know.  How much will this affect commerce?  We don’t know.

 

Investing in such an environment is difficult to say the least.  The reality is we are always investing in an environment filled with uncertainties.  We sometimes fool ourselves into thinking otherwise, but shocks like these always lurk nearby.  The markets almost certainly will continue to be volatile until we get a better handle on this virus.  However, once there is a sense that the worst is behind us, the markets will rally.  Perhaps that happens soon.  Perhaps it will happen when the markets are 10-20% lower.  Not to sound redundant, but we just don’t know.  During this time, we will be looking for investment opportunities in companies we have found difficult to buy because of their high valuations.  Our hope is that by the end of this crisis, your portfolios will be stronger than ever.  In an effort to leave you with one positive thought: pandemics, like everything in the world, are temporary. The Spanish Flu devastated the world in 1918, yet the Roaring Twenties followed not long after.  We can get through this.

Sincerely,

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Tony DiGiovanni

2020 New Year

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Happy New Year!  Happy new decade.  Considering this decade starts with 2020, can we expect perfect vision as to what the future will bring?  Probably not.  However, we will continue to assess the probabilities and make the best, informed decisions possible.  In 2019, there were very few poor investment decisions other than to not invest at all. Every major asset class went up in value.  The US stock market rose almost 30%.  International markets climbed over 20%.  US fixed income markets improved about 10%.  Even oil prices eked out a nice return in 2019.

News Vision

This coming year should be interesting.  The election will receive a lot of attention from journalists on the heels of the impeachment of our sitting president.  Though the House voted to impeach President Trump, the Senate is extremely unlikely to remove him from office highlighting a major political divide in this country.  In a December article of The Wall Street Journal, Gerald Seib referred to a WSJ/NBC News poll showing that 91% of Republicans approve of President Trump while only 6% of Democrats do.  That 85% gap is the largest on record.  For some perspective, the worst the divide ever got during the Obama administration was 65%.  For President Carter, the worst was only 16%, and he was a one-term president.

The polarization seems to be driven at least in part by modern technology and media coverage. The algorithms on our devices stream one-sided news to us. It takes effort to see coverage from multiple perspectives or even to find neutral coverage. For those interested in where those biases lie, use the button to see an infographic on the subject: 



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At least members of Congress realize American citizens would like them to work to improve the public good even while they debate the merits of impeachment. They recently passed two major pieces of legislation. The first is the new North American Free Trade Agreement (NAFTA), now called The United States, Mexico, Canada Agreement (USMCA).  This agreement tweaked NAFTA adding more labor rights and language to protect digital rights.

The second piece snuck its way into the spending bill that funds the government for the next fiscal year.  It is called the Setting Every Community Up for Retirement Enhancement (SECURE Act).  Clearly, a whole team of wonks was needed to make that acronym work.  The Act contains several interesting new rules.  For starters, the required minimum distribution age was bumped to 72 from 70½.  It is not retroactive, so it only affects people who turn 70½ in 2020 and beyond.  Secondly, the Act allows annuities in 401(k) plans.  While this probably won’t affect too many of our clients, it will require a close analysis of the implemented provisions; annuities are generally expensive products, but may be appropriate in some situations.

Perhaps the most significant new provision is the elimination of the stretch IRA. Previously, inherited IRAs to non-spouses had to be distributed throughout the beneficiary’s life.  Thus, for a child beneficiary, the life of the IRA stretched well beyond the IRA’s original purpose which was to provide retirement income to the original owner.  Now, all inherited IRAs must be distributed within ten years.  This will create interesting tax situations.  People who inherit an IRA during peak earnings years will now pay taxes at the highest possible tax rate.  Thus, we’ll need to perform more multi-generational tax planning to create the most efficient strategies.  Roth conversions will be even more valuable if they can be done at a lower tax rate during the aging parent’s life. Roth IRAs will also need to be distributed in ten years, but there are no tax consequences.

Market Vision

How strong is the economy?  Even this seemingly simple question is open to debate.  The nearly 30% rise in the stock market in 2019 suggests a strong economy.  However, if it is so strong, why did the Fed need to cut interest rates?  Earnings actually fell for S&P 500 companies this year.  The entire gain in the market therefore came from a 2% dividend yield and a 30% increase in the market multiple.  Of course, the market is generally forward looking.  The 19.8% drop in the S&P 500 in the fourth quarter of 2018 could simply have been in anticipation of the earnings recession we’ve had this year.  The rebound in 2019 is suggesting a pickup in earnings growth for 2020.  Presently, analysts do expect a 14% rise in earnings.

The economy as measured by Gross Domestic Product has been stunningly steady and consistent at around 2%.  This has been true for much of the past decade despite recovering from a financial crisis.  It is the first full decade without a recession in US history, though GDP fell during two quarters in 2011. Recoveries from financial crises are notoriously difficult because the major deleveraging that usually takes place stunts growth.  It is therefore not surprising GDP hasn’t grown faster. The low growth makes the economy more susceptible to shocks. This makes a decade long streak all the more impressive.  Still, we would normally see government debt as a percentage of GDP shrink after such a long recovery.  It’s actually going the other way.  Could we be borrowing against tomorrow’s growth for gains today?  There are a lot of positive trends for 2020: Earnings are growing, the tariff wars are subsiding, the Brexit deal is nearing, and all this while employment growth continues, and interest rates are stable.  Beyond that, well, we’ll probably need a new prescription to see what follows. 

White Pine Vision

We officially hired Michael Molitor as a research assistant.  Michael is a recent MSU grad, so our ‘house divided’ adds another to the green team.  He is presently working toward a Chartered Financial Analyst (CFA) designation and sat for level I in December.  There are two major designations in the investment advisory space: CFA and CFP.  A CFA is a graduate level program that focuses on valuation analysis, portfolio management, and ethics.  To pass, you must successfully complete three rigorous tests that are each six hours long and have over four years of work experience in the field.

Will Johnson, hired just over a year ago, has the other designation, a Certified Financial Planner.  The CFP is also a graduate level program.  It is broader in scope, though not as deep in any one subject.  It covers general areas of retirement planning, insurance, estate planning, taxes, and ethics.  CFPs must complete a course that covers these major topics, pass a six-hour exam, and have three years of work experience.

As many of you know, our team spends lunch time sharing the challenge of the Wall Street Journal crossword puzzle nearly every day.  While each of us might struggle to complete a puzzle alone, our diversified knowledge base usually allows us to quickly finish it together.  This serves as an apt metaphor for the team we are building here at White Pine. Each talented member’s skill set complements the others’ abilities and adds to the strong ethical and family-oriented culture Russ has carefully cultivated.  The meaningful work we do and relationships we form at White Pine are extremely fulfilling, and we eagerly look forward to serving our clients to the very best of our collective abilities in 2020 and beyond.

Sincerely,

Anthony J. DiGiovanni, CFA