Author: Antonio Rodrigues

03 Apr Market Update – April 3rd, 2020

Hello,

We begin today with a couple of comments on our collective state of mind, and on a decision-making construct we find helpful, before concluding with an update to our three possible scenarios from a month ago.

From talking to clients, and amongst ourselves, it feels like there was a collective realization in America this week that the household isolation could go on for a while—at least through April. As more states implement stay at home restrictions, upwards of 90% of the US population is now covered by such an advisement. Without being psychologists ourselves, we feel that this illustration showing the mental stages of change fits pretty well with what we have been hearing from people. As a country we are collectively realizing and grieving for what has been lost—hopefully not anyone’s loved ones but, more simply, our daily lives have changed. This isn’t a snow day and we aren’t going back to normal “in a couple of days.” Kids are home from college, homeschooling is happening in our kitchens, vacations have been cancelled, no more social activities, weddings are being postponed or held without family and friends, and on and on. Collectively we put the country somewhere between stages “3-4” as we adapt and begin searching for our new reality.

We also wanted to share with you a way to think about what you are seeing in the news–an organizing framework to help make sense of the endless stream of stories. If nothing else, it may give you a new trivia question for your video chats with friends and family! Air Force Colonel John Boyd is credited with creating “The OODA Loop”. That stands for observe–orient–decide–act and was a process-oriented decision-making construct for military leaders facing an opponent in the field. The approach explained how the speed of decision making could overcome an opponent with the goal being to build an organization that could quickly determine what was important in a chaotic situation, make a decision and implement it, and then immediately gather feedback. Then they could determine what was working and what was not, make new decisions and start the process over again. While developed by an Air Force officer, the US Marine Corps perhaps most effectively exemplified its way of thinking.

Some basic tenets were that, as the nineteenth-century Prussian military commander Helmuth van Molke said, “No plan survives first contact with the enemy”. Things are going to be wrong. Things are not going to work. Things are going to have to be changed. That is ok, in fact it should be expected. The military has had decades of practice institutionalizing this kind of thinking and they still don’t get it right every time. Now think for a moment about any government bureaucracy. Does quick decision making, flexibility and a lack of blame come to mind? Probably not. As you watch your local mayor, governor, CEO, congressman or president make decisions in this crisis, try to view it through this framework. New information is coming in and they are making decisions and watching the data. Take the “Masks/No Masks” question that is now bubbling up. Should we wear masks in public if we are not sick? Currently it is a “no” but maybe it will become a “yes”. Don’t look to assign blame or how someone “got it wrong” or “should have known”. Instead, try to look at it like people are doing the best they can in a chaotic situation and reacting to new information. In this era of Twitter and constant news cycles, we sometimes overemphasize the speed at which things can actually be accomplished. We have found that to be a helpful construct to use to filter the endless barrage of news.

When this is all over a “9/11” type commission would be helpful for the county—not to assign blame but to make the system better for the next time and to collectively learn some lessons. Hindsight is always 20/20. To complete the OODA loop story, in the military they call this meeting a “hotwash” or “after action report” where all the impacted parties get together after the battle is over to dissect how it went from all sides. What could be better? Are there any systemic problems that can be fixed? The 9/11 commission found that local police and fire departments had a hard time communicating as they used separate radio systems and didn’t practice joint operations often. They found that the US intelligence community was very fractured and that air passenger screenings had weaknesses. Today we have new processes and new institutions that help fight terrorism—we’re confident the US will learn lessons from this crisis as well and emerge stronger. It won’t be pretty or without its petty arguments, but it will happen. We would not bet against the imagination and determination of the American people. It may take us awhile to get going, but once we do, historically we have been unstoppable.

Switching gears from the intangible to the tangible, and now that the Procyon Investment Committee has new information, let’s now look at an update to our three economic scenarios – our base case, unfavorable case and optimistic case. All three are primarily driven by the possible paths of the virus and our collective reactions to it.

Base Case 65% probability: Our odds of the base case occurring improved from a month ago. Healthcare – We have been moderately successful in flattening the curve as the social distancing slowly takes effect across increasing parts of the country. This should lead to an easing on healthcare staff in the coming weeks. Less initially impacted areas learn from early hot zones and there is a sharing/movement of resources. Testing availability, speed, and applications improve. Though there are flare-ups as life resumes in the summer, the virus begins to fade. Unfortunately, the virus does take a meaningful toll on human lives. Economic – large scale fiscal and monetary intervention continues. We experience a short, yet meaningful decline in 2Q20 GDP and a likely 2020 recession. The recovery will be volatile and categorized as a “W” shaped recovery before returning to modest growth in 2021. The stock market bottoms ahead of the peak infection rate, with a moderate decline to earnings along with dividend cuts. The recovery is influenced by jitters surrounding further outbreaks. Unemployment numbers will shoot dramatically higher and then peak in the coming months as the CARES act makes its way to those in need and the economy begins to restart. The political system, awake to the dangers, continues to function effectively albeit with the continued partisanship. Gatherings – As society makes new habits, we feel that our economy and citizens will be successful in adapting to the new normal. Some things will go back to normal while other “new habits” may persist, presenting challenges to some businesses and new opportunities for others.

Unfavorable Case 15% probability: Our odds of an unfavorable case are not zero but drop slightly from a month ago after seeing federal action, improvements in other countries, and US state reactions. Healthcare: The social distancing effort was begun in too fragmented a manner or restarted too soon to effectively flatten the curve. The virus overwhelms the healthcare system in most states, fails to be seasonal or has a material resurgence in the fall. Mental health becomes an ongoing issue for many. Economic – A deep lasting recession occurs as social distancing is in place for many months and businesses fail while waiting to get restarted and the ineffective government response fails to help the unemployed. It is characterized as an “L” shaped recovery meaning it takes a while. Market – Continued selling across equities goes to a new low, significant selling in fixed income as well as major stress on balance sheets leading to large scale dividend cuts and some insolvencies. Employment: Continued significant layoffs in the small business sector, now moving into larger corporations as demand shifts. Unemployment is slow to decline as a self-reinforcing drop in demand occurs. Mental health becomes an ongoing issue for many. Gatherings: Citizens prefer not to gather due to lack of confidence or government orders. Schools, sports and other events do not resume as expected in September. Resumption of normal social activity takes far longer than initially expected. The political system shows cracks from the stress.

Optimistic Case 20% Probability: Our odds for our optimistic case remain the same as they were in early March and slightly higher than the unfavorable case. Healthcare facilities begin to see personal protective equipment arriving in time as new supply chains and increased cooperation comes online. Lessons learned from early hot spots command effective responses from other areas allowing for a more effective flattening of the curve. The virus proves seasonal and does not return in the Fall due in part to increased global health care coordination. New testing, treatment, and vaccinations are discovered and brought online faster than currently expected. Economic – The government fiscal and monetary efforts prove adaptable and in scale and pace with the crisis. They prove effective in acting as an insurance policy for impacted people and businesses allowing them to successfully restart the economy by the summer. We would see a sharp “V” shaped recovery in GDP and economic activity as suppressed demand drives growth in a sharp upward direction. Market – The March lows prove to be a bottom in equities, small cap stocks lead the recovery. Employment – Unemployment claims initially spike but begin to decline as business resumes. Gatherings – Life resumes with some positive societal changes taking place after the forced shutdown. We learn lessons from the crisis to make the country more prepared, less political, and more caring in the future. “I remember when gas was $2/gallon” stories flourish.

As Winston Churchill is alleged to have said, “You can always count on Americans to do the right thing, after they have tried everything else.” While people are dying and this is a very serious event in everyone’s life do not lose faith in our collective spirt, ingenuity and determination.

Be Well. Be Informed. Be Not Afraid.

06 Mar Reflections on unsettled markets, elections and taxes – March 6th 2020

As February trading concluded on Friday, February 28, the S&P 500 index finished in correction territory at 2,954.22, down 12.8% over the seven-consecutive loss-days from its February 19 record high of 3,386.15. All 11 of the S&P 500 industry sectors were showing year to date losses, and fully 95% of the S&P 500 companies were down 10% or more from their highs. Flows of capital were instead allocated into perceived safe–haven assets, driving U.S. Treasury two-year yields to 0.878% and 10-year U.S. Treasury yields to a new record low of 1.127%. Even as Federal Reserve Chair Jerome Powell inspired a Friday intraday rally when he indicated that the Fed is prepared to lower interest rates to protect the economy from the spreading economic slowdown, the Chicago Board Options Exchange VIX volatility index spiked to 40.11, its highest close since August 2015, which witnessed three devaluations of the Chinese yuan and a 43% two-month decline in the Shanghai Stock Exchange index. Gold finished at

$1,564.10 per troy ounce (+2.9% year to date) and West Texas Intermediate crude oil closed at $44.76 per barrel (-23.1% year to date).

On Tuesday March 3, the US Central Bank voted to perform an inter-meeting Fed Funds rate cut of 50 basis points, lowering the rate by which banks lend to each other to a target of 1.00-1.25%. The equity market initially digested the signal of this cut as an appropriate response given the recent volatility and rallied across all sectors Monday. However, while the response was initially positive, it appears many investors took this Fed action as a signal that the economy is at serious risk of a slowdown and the markets sold off as a result. Predicting the possibility of how fear over the spread for COVID-19 may impact the current global economy is difficult, and the market swings are a clear indication that investors are temporarily not sure where to turn.

Procyon’s investment committee has discussed the reactions and possible outcomes and thought we might share how we’ve attempted to apply some basic logic to the current series of events.

It is becoming apparent that although the rate of new COVID-19 infections in China has slowed, a series of rather draconian restrictions (including quarantines, isolation, travel bans, lockdowns, contact tracings, and other strict measures) has been necessary to achieve this within the world’s second largest economy and most populous nation. Such measures, however, have created headwinds for the Chinese economy—and thereby may have global implications, due to a much more intertwined world than just 10-15 years ago.

In our opinion, the continuing flight-to-safety decline in bond and money market yields and the further selloff in equity prices is being driven by increasing concerns over the spread of the coronavirus within and between other countries in Asia, the Middle East, and Europe, coupled with emerging realizations that

(i) an effective vaccine will take a longer time than generally anticipated to test, develop, and administer; and (ii) it is only a matter of time until the United States experiences outbreaks followed by deleterious effects on individual, corporate, and governmental behavior — producing unanticipated downward revisions to GDP growth and profit forecasts. For example, on February 27, Goldman Sachs predicted that earnings for S&P 500 companies would show zero growth this year, after earlier predicting that they would increase 5.5%. As of now, our call is for low to mid single-digit S&P 500 earnings growth in 2020, based upon some likely further policy stimulus, if necessary, and more of a V- shaped economic contraction and recovery.

It is important to keep in mind that our cautious stance (before this market correction in the S&P 500 and other equity indices commenced) has been based upon three main factors, among others:

• lofty price-earnings and price-to-sales valuation levels in growth companies, many of which were in the 95 to 99th percentile relative to historical
• the more than a decade-long age of the equities price advance and S. economic expansion; and
• a significant degree of complacency as evidenced in persistently bullish investor survey readings and low volatility

For now, we envision three possible scenarios going forward:

Base Case, 60% probability

The following factors: warmer weather; various preventive epidemiological and public health measures; some degree of continued and measured monetary stimulus; and the experienced realization that — even with a possibly high infection rate and quite unpleasant side effects, the coronavirus mortality rate is quite low; leads to a short and meaningful decline in the economy in 2Q20, followed by a similarly rapid recovery, back to or slightly below earlier forecasted levels of economic growth. Cash levels can be slowly and judiciously deployed into diversified portfolios, continuing our emphasis on high quality portfolio design and asset allocation.

Optimistic Case, 20% probability

The above scenario occurs but with large scale stimulus measures launched across a broad, coordinated front to counteract increased worries over the potential negative economic and financial impacts of the spread of the coronavirus globally, and in the United States, potentially including:

• massive monetary, fiscal, and deregulatory stimulus by the Chinese authorities;
• immense monetary stimulus by the Federal Reserve in the form of swift and continued larger-than-expected reductions in policy interest rates and a potential resumption of large-scale Quantitative Easing; and
• extensive fiscal stimulus in the form of across- the-board corporate and individual tax cuts and additional federal government spending

These actions are followed by sudden and sharp equity price recoveries, in which we would emphasize technology, consumer discretionary, industrial, materials, and energy companies.

Unfavorable Case, 20% probability

High levels of indebtedness, and lingering economic and psychological aftereffects of the coronavirus crisis, lead to a broad decline in hours worked, employment, wage growth, consumer confidence, and personal consumption, bringing on a recession in the second half of 2020, which is exacerbated by late and/or ineffectual policy responses and fears (unfounded, in our view) that it is a replay of the global financial crisis of 2008-2009. In such a scenario, emphasis should be placed on money market instruments, high-quality fixed income securities, and defensive equity industry sectors such as utilities and high-quality companies paying well-protected dividends.

We have been counseling and continue to advise diligence and caution — with benchmark duration, higher-grade exposure in the fixed income realm, emphasizing high-quality companies whose intrinsic business models remain fundamentally sound, in defensive sectors with reasonable earnings multiples and well covered dividend support.

A Quick Lesson on Volatility Spikes

The “VIX” represents the ticker symbol and the popular name for the Chicago Board Options Exchange’s CBOE Volatility Index, a popular measure of the stock market’s (and financial markets’ more broadly) expectations of volatility. The VIX is computed and disseminated on a real-time basis by the CBOE, and is sometimes referred to as the “fear index” or “fear gauge.” Traders on the floor of various options and futures exchanges have for several years employed a shorthand expression regarding the VIX volatility measure: “When the VIX is low, it’s time to go slow, and when the VIX is high, it’s time to buy.” In other words, a low VIX reading usually indicates a fair degree of investor complacency, and sharply elevated readings generally reflect widespread concern — sometimes, even panicked selling — associated with equity market washouts that may signal a cyclical bottoming in asset prices. Mindful of the continuing degree of uncertainty relating to the impact of the coronavirus on the global economy, our recommendation is that investors should remain aware of the VIX level as a general barometer (rather than a precise thermometer) of financial market sentiment, viewing a series of too-low readings with ongoing skepticism and by contrast, considering significantly high readings as potential signposts for adding funds to the equity markets.

Equity Valuations Still Above Average

 The fundamental drivers of all asset prices — including stocks; bonds; real estate; agricultural, industrial, and other commodities; precious metals; and even such asset categories as jewelry, art, and collectibles — are driven by various combinations of:

• fundamental forces (such as earnings, economic trends, and dividend, interest, and rental payments);
• valuation measures (relating prices to revenues, earnings, book values, and other measures); and
• psychological, sentiment, and technical factors (such as surveys of bullish and bearish views, initial public offering and merger and acquisition volume, aggregate trading activity, charts of price trends, new highs compared to new lows in prices, advance-decline lines, and moving-average computations).

 While we believe that fundamental factors tend to be the preeminent forces on asset prices during extended upward or downward moves, and psychological, sentiment, and technical factors tend to exert a dominant influence at major turning points (with extreme euphoria and optimism characterizing market tops, and extreme despondency and despair characterizing market bottoms), valuation metrics are used as a reality check and to provide useful and much needed historical perspective on asset pricing. Prior to the recent coronavirus-driven changes in equity, fixed income, precious metals, energy, and currency prices, it can be seen from the above table that many valuation measures of the Standard & Poor’s 500 composite index as of year end 2019 were registering in the 88th to 99th percentile of their historical valuation readings.

Such elevated valuation measures — including U.S. Market Cap/GDP; Enterprise Value/Sales; Enterprise Value/EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization); Price/Book Value; Cyclically Adjusted P/E; and Forward P/E — have been an important influence on our multi- month message of caution and conservative portfolio positioning. Even though the S&P Earnings Yield (the inverse of the Price/Earnings ratio) minus the 10 year U.S. Treasury yield was only at the 28th percentile (due to ultra-low interest rates), in our view, the recent pullback in most of these valuations still leaves them at well-above-average historical levels and underscores our continued counsel of vigilant, careful, and cautious investment strategy and asset allocation.

Equity Performance in Presidential Election Years

 Widespread wisdom concerning U.S. equity market performance in the four years of a presidential term—promulgated among other market prognosticators, by Yale Hirsch in The Stock Trader’s Almanac, with his “Presidential Election Cycle Theory“ — usually holds that:

• the best year is year three; followed by
• year four, as various forms of economic stimulus may be applied in advanceof the election itself;
• year one, characterized by the good feelings after a national election; andlastly,
• year two, when the effects are felt of whatever economic and policy “housecleaning” has been

For the 23 presidential election cycles since 1928, the upper panel shows the mean (which is the conventional arithmetic average) and the median (defined as the midpoint) of the S&P 500 average returns in each year of a presidential term. We caution that these outcomes reflect average performance, and a given presidential cycle can deviate, sometimes meaningfully, from the results generated over the past 92 years. This can be seen in the lower panel, which shows the Standard & Poor’s 500 performance for the 42nd, 43rd, 44th, and 45th U.S. presidencies. For example, in year four of President   Bush’s   second   term,   the   S&P   500 substantially lagged the performance of the other three years, and in both of President Obama’s terms, the first two years produced the best performance.

As calendar year 2020 progresses toward Election Day on Tuesday, November 3, we advise to be aware of the psychological and sentiment impact that is likely to be felt on quite a number of industry groups during the upcoming presidential campaign. With corporate taxation, industry dominance, and market power likely subjects of discussion and debate, sectors expected to be in the spotlight include, among others oil, gas, coal, and hydraulic fracturing; pharmaceuticals, biotechnology, and medical devices; and social media and other technology- enabled companies. Investors would be wise to give careful consideration to the intermediate- and longer-term implications of this year’s elections for specific holdings in these and other industries.

Tax Proposals of Presidential Candidates

Regardless of one’s political persuasion and tax bracket, we think it is quite important from an investment standpoint to pay close attention to the likely post-election contours of the top marginal tax rates on labor and investment income. Investor psychology, consumer behavior, and corporate profitability are influenced to a significant degree by the trend and level in federal (as well as state and local) taxes on labor income. In addition, taxes on capital (investment income) affect investment, a major determinative factor influencing productivity growth, and thus, wage growth.

Quite apart from the media and debate attention given to several Democratic presidential candidates’ proposed single-payer health care and wealth taxes, the table to the left sets forth the current federal top marginal tax rates on labor and investment income under current law and also shows the size of the much-less-publicized tax increases on labor and investment income proposed by three of the Democratic presidential candidates. (Editor’s note- Buttigieg and Warren have both suspended their campaigns at this point) The top marginal federal tax rate on labor is currently 40.2%, (including the 2.9% Medicare tax) with the proposed top marginal tax rate proposed by the three (Buttigieg suspended campaign 3/1/20) cited presidential candidates ranging from 51.8% to 69.2%. The table also shows that the top marginal tax rate on investment income is 23.8%, with the proposed top marginal tax rate proposed by the three cited presidential candidates ranging from 43.4% to 58.2%. Our counsel is to pay particular attention to these and other candidates’ tax proposals, focusing on their impact on corporate, consumer, and investor behavior.

For additional perspective on the evolution and complexity of the U.S. federal tax code, we share the following thoughts:

Approaching the annual April 15 due date for tax filing, we also offer the following reflections relating to the history of federal income taxation and the size of the federal tax code. The United States tax system has evolved through the nation’s history, from an initial revenue- generation reliance on tariffs, with new income taxes and other levies generally introduced during times of war to raise additional revenue, then being allowed to expire once the war was over. In the years after 1900, popular and legislative support began  to build for a continual income tax, and in February 1913 the Sixteenth Amendment was ratified to the Constitution, granting Congress the power to collect taxes on personal income.

According to Thomson Reuters-Refinitiv and Wolters Kluwer CCH (the latter of which has analyzed the federal tax code since 1913), in the first 26 years of the federal income tax, the code only grew from 400 to 504 pages, and even during President Franklin Delano Roosevelt’s New Deal, the tax code came in comfortably under 1,000 pages. Changes implemented during World War II increased the total code (including appendices) to 8,200 pages; by 1984, it had swollen to 26,300 pages, and as of early 2018, several Congressional and media commentators have pointed out that the federal tax code exceeds 80,000 pages. The length of the actual current actual tax code itself runs in the neighborhood of 3,000 pages, with over 75,000 additional pages devoted to the inclusion of: all past tax statutes; Internal Revenue

Service regulations and revenue rulings; and annotated case law covering court proceedings surrounding the tax code.

If you made it all the way to the end, clearly you are on your second cup by now. We hope this was informative. All of us at Procyon stand by to help if you should have any questions.

Warm Regards,

Procyon Partners

Source: Bloomberg, Data Analysis, 1/2017-Present

Source: Zephyr, Data Analysis, 1/2017 – Present

Source: Morningstar, Data Analysis, 1/2017 – Present