Research Note: Three Market Scenarios and Possible Responses

As you may know, my views on forward looking scenarios do not have an impact on the target weights, but they do influence my review of portfolio designs as I evaluate whether there is a change in the economy or markets that requires a shift in their designs.  As an example, the recent price decline was a shock to many investors and affected their short-term risk tolerances. I adjusted the model portfolio lineup and my communication to make it easier to adjust the aggressiveness of one's account.

I am currently evaluating three different scenarios for the path ahead to determine what, if any, changes might be made to model portfolio design to accommodate scenarios more extreme than the one I consider most likely.

The Likely Scenario - Economic Activity Constrained to "Virus Time"

Current expectations:
  • Unemployment will spike dramatically over the near term and stay high for many months.
  • Bankruptcies will spike as well.
  • The Federal Reserve and its counterparts around the world have already stated emphatically that they will do “whatever it takes” to limit the damage of this crisis. Their actions have been consistent with their statements. Additional actions are expected.
  • Congress and the President have enacted stimulus packages and have promised more
  • Social distancing will continue in some form until a vaccine is developed in 12+ months. Until that time, travel and entertainment, dining out, and shopping for non-essentials will be severely limited.
  • Economic activity will begin to resume when there is an effective and scalable way to test for antibodies, which can identify people immune to Covid-19 who can safely return to work. The antibody test is some months away.
  • More people are working effectively at home than would have been possible a few decades ago or certainly during the Spanish Flu in 1918-9. Economic activity is continuing during lockdown, which may be the source of some positive surprises.   
  • The level of bad news in the market will likely be higher in the US when death rates spike over the next several weeks, employment reports come out, and the scale of the immediate economic damage becomes more apparent.  
  • Investors will see some light at the end of the tunnel as Europe moves through its curve of infection, mortalities decrease, and people return to work.  Asia is more advanced in that sequence. India and South America may be behind the US.  
Earlier than expected development of vaccines and antibody tests will accelerate this timeline and would be key events. 

The fact that we just recently had a major financial crisis (2007-9) with bailouts and stimulus packages is important to the current situation. The Global Financial Crisis was just over ten years ago as opposed to something we could only read about in history books. Many of the same people and institutions have been involved in both crises and I believe there is general dissatisfaction with how the past rescues of big corporations and financial institutions failed to benefit the consumer as much as needed. In the subsequent years, interest rates have been pushed lower and lower to encourage growth.

But the debt load carried by the economy has expanded (because of low rates) to the point where any increase in interest rates has a devastating effect on both corporations and consumers. We seem to have come to the end of the long trend toward lower interest rates that started in the 1980s when short term rate (2-year treasuries) was 16.7% in September of 1981 to the current rate of 0.23% (March 2020). While Japan has had negative interest rates for a few years, low rates distort corporate and individual investment and borrowing decisions.

This current crisis may be a way of clearing out the debt load and resetting debt loads and interest rates to a more healthy and sustainable relationship. Thus, the pandemic can be thought of as precipitating important changes that would have come about without the virus but in a perhaps slower and probably less comprehensive manner.

If this scenario is valid, our current lineup of model portfolios is likely to navigate the 2020 recovery reasonably well. The design of the current model portfolios is based on analyses of prior recessions and market crashes and their recoveries. Our portfolios emphasize the DJIA because of the quality and liquidity of the companies it contains. Should there be widespread bankruptcies in the broader market, the DJIA companies generally considered strong and some of the DJIA companies may actually grow stronger as they absorb customers from the competition. For reference, the top 10 holdings of the DJIA are:
  • Apple Inc
  • UnitedHealth Group Inc
  • Home Depot Inc/The
  • Goldman Sachs Group Inc/The
  • Visa Inc
  • McDonald's Corp
  • Microsoft Corp
  • Johnson & Johnson
  • 3M Co
  • Boeing Co/The
The DJIA has technology companies (Apple, Microsoft) and healthcare companies (UnitedHealth Group, Johnson & Johnson).

The model portfolios currently hold US 10y Treasury bonds also because of their quality and liquidity. In times of crisis, quality and liquidity make it easy to adjust our asset allocations and to remove money from the market. We do not hold corporate bonds because they may be difficult to trade in times of stress.

A More Positive Scenario

I can imagine a more positive outcome for the global economy from the current events. Many individuals and businesses will suffer and be forced into bankruptcy. In this scenario, the changes happen quickly. There will be some form of debt forgiveness, perhaps in the form of student loan forgiveness or mortgage relief. Reduced debt load among consumers and businesses and the global economic stimulus will encourage rapid economic growth. Fiscal stimulus will help rebuild infrastructure faster than would have otherwise occurred and provide future efficiencies. Surviving business will grow quickly with a lower debt load. In the next couple of years, we may begin to see hints of inflation.

If this scenario becomes more likely, it may be helpful to incorporate inflation-linked bonds as a component.  I have been running inflation signals sets since 2007 and can incorporate them if needed.

A More Negative Scenario

Even though we are seeing an extremely fast response from governments around the world, the inevitable economic contraction may be extremely difficult for many businesses and sectors of the economy. They will not muddle through easily. Individuals and business bankruptcies will grow more than expected right along with unemployment rate. Financial stress and dislocation will reverberate through the global economy for many quarters despite the speed and magnitude of the government response. Economic growth will not rebound evenly throughout the US or global economies.

I am evaluating variations of the current model portfolios that seeks to have more exposure to the parts of the economy that may benefit during the more negative scenario. I tentatively call it the 2020 Recovery model portfolio and its structure is based on the Diamond-Onyx Mixes. It uses existing signal sets (developed over 7 years ago), which makes the historical simulations far less vulnerable to back-fitting the solution to the time period just experienced.

The thrust of the modification is to have greater exposure to consumer staples companies, technology companies, and health care companies. These sectors may experience better growth than other areas of the market.

Consumer Staples companies tend to have steady business in difficult economic times. They may get a boost as more people eat at home and seek to make life at home comfortable and pleasant. We currently use the ETF XLP for Consumer Staples companies in the Onyx mixes.  The modification would increase the allocation to this ETF.  The top 10 holdings of this ETF are:
  • Estee Lauder Cos Inc/The
  • Mondelez International Inc
  • Coca-Cola Co/The
  • Procter & Gamble Co/The
  • Walmart Inc
  • JM Smucker Co/The
  • Altria Group Inc
  • Sysco Corp
  • Kraft Heinz Co/The
  • Archer-Daniels-Midland Co
The 2020 Recovery would obtain greater technology exposure by having an allocation to the ETF QQQ, which tracks the NASDAQ 100 index. The Nasdaq 100 Index is composed of 100 of the largest international and domestic companies, excluding financial companies, that are listed on the Nasdaq stock exchange, based on market capitalization. Therefore, QQQ is heavily weighted toward large-cap technology companies and is often viewed as a snapshot of how the technology sector is trading. The growth of online commerce, new technological solutions to address workplace challenges (e.g. remote working and online meetings and classes), the growing need to provide social connections in in a socially distanced world, and investment in new technologies to solve emerging problems will likely boost the NASDAQ. The top 10 holdings of QQQ are:
As you can see, there is overlap with the DJIA.  Apple and Microsoft are among the top 10 holdings of both indexes and ETFs.

Health Care companies would be included in the Covid 2020 Recovery model portfolio.  They are likely to get a direct boost from consumer and government spending because of the pandemic. These companies might also be affected by changes in the healthcare system as we move through the recovery. Should this sector deteriorate as an investment, it may be removed from the model portfolio. We would have an allocation to the ETF XLV. Its top 10 holdings are:
  • Johnson & Johnson
  • UnitedHealth Group Incorporated
  • Merck & Co., Inc.
  • Pfizer Inc.
  • Abbott Laboratories
  • Bristol-Myers Squibb Company
  • Amgen Inc.
  • Medtronic Plc
  • Eli Lilly and Company
  • Thermo Fisher Scientific Inc.
It is important to recognize that the top holdings in the major indexes are similar; there is a fair amount of overlap. Thus, the change from the current structures may be less than it appears.  Please see this page for the holdings of the ETFs mentioned: https://marketresilience.blogspot.com/p/etf-holdings.html

The resulting model portfolio has similar characteristics of the Onyx mixes currently offered, although it holds more ETFs. While the design of the existing model portfolios considers a very long frame based on historical experiences, the Covid 2020 Recovery portfolio is more thematic and is more likely to be modified over time.

After additional testing, I will report my findings on this evaluation.