Lessons from the trail
Prior to having our son, my wife and I took annual hiking trips to Alaska. Hopefully, we can soon take him up there with us. Although I’m sure I’ll be the one tasked with carrying him on my shoulders for 10-mile treks… We’ve enjoyed our trips so much that we even had our wedding there on a beach in Seward. Every trip we have tried to go someplace new and, by now, have been pretty much to all corners of the state. Through lots of trial and error, we’ve learned that the keys to having safe and enjoyable hikes are to overprepare and always anticipate your next move. For the most part we’ve managed to keep ourselves out of trouble and have enjoyed being in pristine wilderness without another person in sight for miles.
The only time I’ve ever really put myself in danger was when I let my guard down after finishing a hike along a riverbed in Denali. Coastal brown bears are remarkable creatures and can be intimidating – clocking in at up to 1,500 pounds – but they consume so much salmon that they rarely pose a danger to humans. Interior brown bears – grizzlies – are another matter. Though half the size, they are more the scavenger type than glutton, and tend to be more aggressive. Bears, like people, prefer traveling the easiest course, and riverbeds in Alaska act as makeshift bear superhighways – plus there is always the chance of finding an easy meal near the water.
After we finished hiking along this particular riverbed – taking a few detours to avoid some bears in the distance – I became lazy, both physically and mentally. Thinking we were now in the clear, I walked up the steep bank to get to the main trailhead that led us back to our campground. Ahead of me was a thick layer of willow shrubs. I was tired and rather than spend an extra minute to walk around them, I told my wife I was just going to head through to get back to the trail. That. Was. Dumb. Willow shrubs, as I had known, are a primary food source for Alaskan moose.
As soon as I pushed the shrubs aside, I found myself standing face to face with a giant bull moose. For all the fear people have about bears, moose – especially when surprised (and during mating season, which it was) – are far more dangerous. Males even more so. After standing frozen in shock for a brief moment, I regained my composure and slowly backed up. Fortunately, the moose let this blunder pass and didn’t charge.
I let my guard down and almost paid a huge price. It’s a mistake I have never made hiking again. Risk management in the investing world isn’t that much different than when hiking. You always need to stay focused on navigating the path ahead rather than take comfort in finishing a hard leg of the trail.
We have just gotten through an extremely challenging year and most people and investors are focused on sunnier days ahead. But don’t be like me on that trail. This is still an elevated risk environment for markets and the persistence of Covid may pose a challenge to near-term economic growth expectations. Markets are not priced for this and any adjustments to near-term forecasts may trigger a period of heightened volatility.
Just because the finish line is in sight – and it surely is with vaccinations ramping up – does not mean that the last leg of the trail is all in the clear. We will get to the other side of this pandemic, but, like a good hiker, we have to keep our focus attuned to our surroundings.
For our more detailed thoughts we shared with clients on the current market risk environment, please keep reading below. And for all of our previous market updates visit: https://www.karmincapital.com/letter-archive. Always happy to discuss the investing environment and portfolio/risk management with anyone if interested.
Stay safe out there,
Stuart
P.S. Please see all the relevant disclosures at the end...
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A little more a year ago, most U.S. citizens and investors dismissed the scenes of Chinese provincial lockdowns and Italian hospitals overflowing with Covid patients as a healthcare crisis that surely couldn’t happen here. Reality turned out to be much worse than our worst expectations. In recent weeks, global Covid trends have become increasingly concerning. Investors, for now, seem to be largely overlooking these risks, which has given us unease that history may be rhyming, if not repeating. Considering the high degree of economic optimism currently priced into markets, investors need to make sure that their portfolios and psyche are prepared for the possible volatility that could result from markets adjusting to decelerating near-term growth expectations.
We want to note at the outset that the concerns we have are all near-term in nature and that we expect the economy to recover and grow in the coming quarters and years. Low interest rates – even in light of the recent move higher in longer-term yields – along with significant federal deficit spending and pent-up consumer demand are providing a powerful tailwind for the equity markets.
Still, we want to prepare you for the possibility that the recovery could face some Covid-related obstacles that cause investors to reassess their outlooks. Because positioning has shifted so rapidly over the last six months (for instance, investors have sold down bonds, driving yields higher, and have favored value stocks over growth) any changing sentiment regarding the economic outlook has the potential to cause sharp reversals of these recent trends. We think the best antidote to volatility is a diversified, long-term investing approach focused on high quality firms trading at reasonable valuations – and should any sector specific or market-wide sell-off occur, we would look to add to our holdings that fit these criteria.
Over the past few weeks, authorities have implemented lockdowns in parts of France, Italy, Germany, Poland, Hungary, Bulgaria and Bosnia.[1] Other European countries are reportedly close to instituting mobility restrictions. Brazil is facing a health system collapse with ICU occupancy rates above 90% in much of the country, and its reported daily death count has surpassed 3,000 (this despite a harsh first wave of Covid last year).[2] The culprit seems to be Covid-19 variants caused by virus mutations, such as the U.K. B.1.1.7 variant and Brazilian P.1. variant.[3] If you are not familiar with these developments you can learn much more from the news and scientific publications than from us, but the gist is that the new Covid-19 variants are proving, in some cases, to be more virulent and harmful than the original strain. And, though the data is limited, some of the new variants may be resistant to current vaccines and naturally occurring antibodies from prior infections.
In the U.S., the rollout of vaccinations has actually been a relative success compared to most Western countries. As of March 23, about 27% of the U.S. population has received 1 dose and over 14% of the population is fully vaccinated.[4] Despite the increased pace of vaccinations (now about 3m per day) and a sizeable portion of the population that has already recovered from Covid, we are still averaging more than 50,000 new daily cases over the last week which is more than the baseline prior to last fall’s surge.[5] The Northeast and upper Midwest have the most alarming case growth trends, which has already caused New Jersey to pause its reopening plans. While the healthcare system remains stable, with hospitalizations just under 40,000 nationally, that is again higher than levels preceding the fall surge.[6] In Europe and developing countries, the situation is far worse on a per capita basis.[7] Other than Israel, the world still a long way from herd immunity.[8]
If vaccines are rolling out and many people have already recovered from Covid, why do these trends matter? First, each new emerging variant poses a risk of reducing the efficacy of current vaccines. For instance, the current mRNA vaccines are less effective against the South African Covid variant B.1.351.[9] Fortunately, scientists are optimistic they can adapt the mRNA vaccines to new variants, but this process takes time. A best-case scenario would be that scientists develop a “universal” Covid vaccine that offers protection from all potential variants, but there is no guarantee of success. Secondly, while most viruses mutate to become more benign over time, as harming the host hinders viral propagation, the rising number of global cases increases the risk of some mutation emerging that is materially more dangerous and virulent. Furthermore, mutations might evade naturally occurring antibodies and memory T-cells from those who have recovered from prior Covid cases. The world is in a race against time to vaccinate. Some countries are not running at all and many more need to be running faster.
Nevertheless, we are not in the doom and gloom camp. Based on our best understanding of the current science, we think that a combination of natural immunity and vaccinations, along with the tendency of viruses to become less harmful as they evolve, should result in either herd immunity or Covid-19 eventually becoming another class of the less harmful coronaviruses that cause the common cold.
As investors, the key issue question is: what’s priced into markets? The environments in which investors can make or lose lots of money are those where a broad consensus emerges or reverses. It pays to be early and on the right side of each shift.
Since news of Pfizer’s vaccine efficacy became public last November, investors who have positioned their portfolios to benefit from stronger economic growth have done incredibly well. Right now, a strengthening economy is still the predominant investment theme – and, in fact, growth forecasts continue to rise (see the below graphic).[10] This has catalyzed a historic selloff in bonds, an increase in inflation expectations, a surge in commodity prices and a dramatic rotation from growth stocks to value and small cap firms whose business models tend to be more levered to an improving economy.
We are not suggesting these growth forecasts will prove wrong, only that markets are not priced for any bumps along the road to get there. Shifting economic expectations due to Covid setbacks would likely result in bonds rallying (driving yields down), commodity prices falling (due to lower anticipated demand) and investors shifting out of value and cyclical stocks and back into both defensive stocks (such as utilities) and growth firms (whose valuations would benefit from falling interest rates and the perceived scarcity value of growth in a potential lower growth environment). Basically, if expectations become more pessimistic, last year’s market leaders would likely return to their leadership status.
Even if Covid has a challenging third wave, we doubt there is the political will at most state and local levels to implement stringent lockdown policies. Even more, we doubt there would be widespread compliance like last spring. We get the sense that most people are eager to return to their pre-pandemic routines. Still, if Covid trends deteriorate in the coming weeks and months, even without mandated stay at home and distancing policies we think part of the population will choose to exercise extra precautions. Such behavior spread across the entire country – and globe for that matter – will have the effect of slowing down the recovery. That creates the risk of an investment environment where actual economic data and company operational performance do not live up to elevated expectations. If this happens, we expect the trends depicted in the below charts to reverse (note that Pfizer released its clinical vaccine data in early November, which is when small cap stocks began materially outperforming large caps and value stocks began outperforming relative to growth).[11]
To reiterate, a harsh third Covid wave and economic deceleration is not our base case forecast. However, we think it is a risk that investors need to take seriously. The mistake most investors made last year was not taking seriously enough the warning signs coming from China and Europe. We would rather raise the caution flag and be wrong than not bring up the possibility of further Covid risks materializing.
The best way to prepare for any risks is to have some diversification in your portfolio. If you are significantly overweight value and cyclical firms, consider adding growth exposure (which has sold off over the last month) to position for an environment where growth firms again take market leadership. Conversely, if you are significantly overweight growth stocks, consider adding some value and cyclical exposure on any weakness as those firms will likely outperform if the economic recovery maintains its footing. If you have no fixed income exposure, bonds would likely perform well if we are faced with increasing economic uncertainty. As we wrote a few weeks ago, we should expect the unexpected. The best way to structure a portfolio with the unexpected in mind is (1) to make sure your equities exposure is aligned with your risk tolerance and (2) for the stocks you do own to be high-quality firms across multiple industries that are trading at compelling valuations, which do not reflect overly optimistic investor expectations. That way, any economic or operational setbacks should hopefully provide cushion against substantial price declines.
Citations and Disclosures
[1] NPR, New Lockdowns In Europe As COVID-19 Cases Soar (March 20, 2021).
[2] NPR, Brazil Is Looking Like The Worst Place On Earth For COVID-19 (March 23, 2021).
[3] U.S. Center for Disease Control and Prevention, Science Brief: Emerging SARS-CoV-2 Variants (Jan. 28, 2021).
[4] Our World in Data (March 23, 2021).
[5] The New York Times (March 23, 2021); Bloomberg LP (March 23, 2021).
[6] The New York Times (March 23, 2021); Bloomberg LP (March 23, 2021).
[7] Financial Times (March 23, 2021).
[8] nature, Five reasons why COVID herd immunity is probably impossible (March 23, 2021).
[9] Reuters, Pfizer says South African variant could significantly reduce protective antibodies (Feb 17, 2021).
[10] Wall Street Journal, Economy Revs Up as Americans Increase Spending on Flights, Lodging, Dining Out (March 19, 2021).
[11] Bloomberg LP (March 24, 2021).
Investing involves risks, including the possible loss of principal and fluctuation of value. Past performance is no guarantee of future results.
This letter is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date noted above and may change as subsequent conditions vary. The information and opinions contained in this letter are derived from proprietary and nonproprietary sources deemed by Karmin Capital to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Karmin Capital, its principals, employees, agents or affiliates, or by Fort Sheridan Advisors LLC, its principals, employees, agents or affiliates. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will materialize. Reliance upon information in this post is at the sole discretion of the reader.
Please consult with your financial advisor to ensure that any contemplated transaction in any securities mentioned in this letter align with your overall investment goals, objectives and tolerance for risk. In addition, please note that Fort Sheridan Advisors LLC, through its wealth management division, Karmin Capital, including its principals, employees, agents, affiliates and advisory clients, may have positions in one or more of the securities discussed in this communication. Please note that Karmin Capital, including its principals, employees, agents, affiliates and advisory clients may take positions or effect transactions contrary to the views expressed in this communication based upon individual or firm circumstances. Any decision to effect transactions in the securities discussed within this communication should be balanced against the potential conflict of interest that Karmin Capital has by virtue of its investment in one or more of these securities.
Additional information about Fort Sheridan Advisors LLC is available in its current disclosure documents, Form ADV and Form ADV Part 2A Brochure, both which are available without charge by contacting Fort Sheridan toll-free at 866-559-9700. You may also request copies by email at [email protected], or access the documents online via the SEC’s Investment Adviser Public Disclosure (IAPD) database at www.adviserinfo.sec.gov, using CRD# 151139 or SEC# 801-70517.
Karmin Capital neither provides investment banking services nor engages in principal or agency cross transactions. Karmin Capital is the wealth management division of Fort Sheridan Advisors LLC. All securities transactions are effected through Western International Securities, Inc. and Fidelity Brokerage Services LLC. Fort Sheridan Advisors LLC is not an affiliate of Western International Securities, Inc. or Fidelity Brokerage Services LLC.
RDC Next, Strategy & Operations Director
3 年With that intro I don’t know how anyone can not want to read this article. Nice article Stuart!