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Quarterly Commentary – Q3 2020

In our third quarter 2020 client letter, we address four prevalent myths as they relate to financial markets and our clients’ portfolios:

Myth #1: The economy and the stock market have recovered
Myth #2: The stock market leaders (i.e., mega-cap tech stocks) will keep outperforming.
Myth #3: If [insert Democrats or Republicans] win the election, the stock market is doomed.
Myth #4: Stocks and bonds are good diversifiers.

To read the entire letter, click here or on the image below!

Quarterly Commentary – Q1 2020

“Weathering the Storm Together”

It is shocking how our lives have changed so dramatically in the span of a few weeks. While these are unprecedented and challenging times, we are grateful that everyone at Morton Capital and their families are safe and healthy. We hope that you and your families are as well. Beyond our company, we are heartened to see the strong spirit of cooperation on display every day in our larger community: hospital personnel and medical professionals exhibiting courage and dedication; pharmaceutical firms rushing to develop a vaccine; industrial companies shifting their businesses to manufacture ventilators; and even a beer brewery helping to produce hand sanitizer and giving it away for free to first responders. We may be isolated in our homes, but we are all truly in this together. We feel confident that we will emerge from this pandemic a stronger firm and community.

 

“The Bull Market Hits the Illiquidity Wall”

In a 180-degree reversal from 2019, volatility spiked and risk assets fell sharply during the first quarter of 2020. The U.S. equity market drop of over 30% from its February peak was the fastest such decline on record. The S&P 500 Index either rose or fell at least 4% in eight consecutive trading sessions, the longest streak in history. Given the sharp stock rally in the last week of the quarter, the S&P 500’s 19.6% loss appeared somewhat tame, especially as compared to broader markets: U.S. smaller company and value stocks and developed and emerging international stocks all experienced meaningfully higher losses. While the negative demand shock affected most commodities, oil was especially hard hit as it collapsed over 65% to the low $20s per barrel. Gold was one bright spot, up close to 4.0% during the quarter after a strong year in 2019. The table below summarizes the first-quarter performance for selected indices versus 2019.

While stock markets and commodities experienced significant volatility, the more unexpected story was the corresponding carnage in bond markets. While U.S. government bonds were up modestly, other major categories of bonds experienced significant losses. The below chart looks at the decline in various bond categories in 2020 as compared to their maximum drawdown during the 2008 crisis as well as their recovery when the markets rebounded in 2009:

Certain types of bonds will undoubtedly face challenges if the current economic climate worsens. However, the sharp selloff in bonds was not only driven by concerns for the future, but also by a wave of forced selling that sucked up all the liquidity in the bond markets. Counterintuitively, higher-quality bonds actually took some of the largest hits since that is where desperate sellers rushed believing that they would have the most liquidity. At this stage, certain bond securities seem to be oversold, as they also were back in 2008. The above chart demonstrates that opportunistic and patient investors who saw this as an opportunity back then were ultimately rewarded with equity-like upside when conditions in bond markets stabilized in 2009. We believe that we are with the right managers to capitalize on these types of moves. We currently have meaningful allocations to bond funds that we categorize as “tactical fixed income,” meaning that the managers have broad mandates to move in and out of various bond market segments depending upon where they see opportunities. These managers are now in a position to take advantage of the current market disruption if they believe it presents an opportunity for the longer term.

 

“Redefining Money at Ludicrous Speed”

In the classic Star Wars spoof, Spaceballs, light speed is not fast enough for Rick Moranis’s evil Dark Helmet. He insists that his spaceship jump to ludicrous speed, causing them to overshoot and lose their quarry. Similarly, recent events feel like they have been played out at ludicrous speed, starting with the fastest 30% decline on record for stock markets, followed up with a comparably fast and drastic monetary and fiscal policy response.

Back in the 2008 financial crisis, various government programs were rolled out by the Federal Reserve (“Fed”) and federal government over many months. In the current environment, government programs to shore up the economy and markets have been launched at a rapid-fire pace. The Fed has announced what equates to unlimited quantitative easing (or “QE”), which is a program where it essentially prints money to provide liquidity to the system. It accomplishes this by buying various securities, ranging from treasuries to corporate bonds, which aims to keep interest rates low and stimulate economic activity. QE was a favorite tool of the Fed’s back in 2008 after it lowered interest rates to zero and ran out of traditional stimulus methods. The scope of this current QE, though, makes the QE from 2008 look like child’s play. The Fed’s balance sheet has already increased to over $5 trillion and is projected to double to over $10 trillion by the end of 2020. These types of numbers are inconceivable in their size. Back in March of 2009, the entire global stock market was valued at around $27 trillion total. Today, we are talking about the Fed, just one of many central banks globally, owning assets of over $10 trillion. These types of policy moves are doing more than just stimulating economies and markets; they are redefining money. Money has historically been thought of as a store of value, but that definition is totally incongruous with the way it is being used today as trillions of dollars (and other currencies around the globe) are created out of thin air to stem the current crisis. The point is not that stimulus is not necessary given the extremity of the current crisis, but rather that there will ultimately be a cost.

 

“Focus On What We Can Control”

While there are many things outside our control in the current environment, there is also much that we can control about our own situations and how we respond to upcoming events. The recent stock and bond market volatility created an excellent opportunity for investors to reexamine and reaffirm their risk profiles. It is natural for investors to think they can handle more risk when markets are going up with very little interruption, as they had for the past decade. But recent events are a better measure of how much volatility investors can handle. Did this latest turbulence keep you up at night or were you confident in your long-term plan? Did you have the urge to get out of risky asset classes or were you comfortable with how your portfolio was positioned? When it comes to risk tolerance, there are two essential components: how much risk you should take to meet your goals and how much risk you are willing to take. The first component is a function of more objective criteria like your time horizon, spending needs and other data that can be input into your financial plan. The second component is all about emotions, but in spite of that it is an equally important part of the equation. Even if your financial plan dictates that you can have a more aggressive portfolio, if emotionally you cannot handle big swings, then that positioning may not be appropriate for you. After all, the best portfolio for you is one you can stick with, in good times and in bad.

Another important situation within our control is whether we have sufficient liquidity or emergency funds to meet our short-term cash needs. Certain asset classes like stocks, or even riskier bonds, are technically liquid on a daily basis. But just because you can sell daily does not mean that it is a good idea. On a short-to intermediate-term basis, stocks in particular should not be thought of as a source of liquidity. Instead, investors should have sufficient liquidity outside of their portfolios to meet their needs and handle any smaller emergencies that may arise. This prevents forced selling at the wrong time.

Finally, we can control how we allocate our portfolios and whether we are positioned aggressively or defensively in any given environment. When risks are heightened, as at present, we believe it is time to be defensive. Rather than avoiding risk (e.g., going to cash), this means favoring asset classes that we feel have more attractive risk/return characteristics than those of traditional stocks and bonds. While alternative assets are not immune to current events, they are typically much less sensitive than those traditional assets. We are in touch with all of our various managers and are monitoring the impact of current events on their portfolios closely. We believe that we are with the right managers that have the right mindset to face these types of challenges. The first order of business is protecting what we have, but if things deteriorate further, there will undoubtedly be opportunities for the longterm as well. We will continue to look beyond short-term noise towards how we can best protect and grow our clients’ assets for the longterm.

Please do not hesitate to contact your Morton Capital wealth advisory team if you have any questions or would like to review your portfolio or financial plan in more detail. As always, we appreciate your continued confidence and trust.

Morton Capital Investment Team

 

 

Disclosures

This commentary is mailed quarterly to our clients and friends and is for information purposes only.  This document should not be taken as a recommendation, offer or solicitation to buy or sell any individual security or asset class, and should not be considered investment advice. This memorandum expresses the views of the author and are subject to change without notice. All information contained herein is current only as of the earlier of the date hereof and the date on which it is delivered by Morton Capital (MC) to the intended recipient, or such other date indicated with respect to specific information. Certain information contained herein is based on or derived from information provided by independent third-party sources. The author believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information. Any performance information contained herein is for illustrative purposes only.

Certain private investment opportunities discussed herein may only be available to eligible clients and can only be made after careful review and completion of applicable offering documents. Private investments are speculative and involve a high degree of risk.

The indices referenced in this document are provided to allow for comparison to well-known and widely recognized asset classes and asset class categories. Q3 returns shown are from 06-28-2019 through 09-30-2019 and the year-to-date returns are from 12-31-2018 through 09-30-2019.  Index returns shown do not reflect the deduction of any fees or expenses. The volatility of the benchmarks may be materially different from the performance of MC.  In addition, MC’s recommendations may differ significantly from the securities that comprise the benchmarks.  Indices are unmanaged, and an investment cannot be made directly in an index.

Past performance is not indicative of future results.  All investments involve risk including the loss of principal. Details on MC’s advisory services, fees and investment strategies, including a summary of risks surrounding the strategies, can be found in our Form ADV Part 2A. A copy may be obtained at www.adviserinfo.sec.gov.

Quarterly Commentary – Q3 2019

“May You Live in Interesting Times”

The above phrase is an English translation of a traditional Chinese omen.  While it seems like a blessing, it is actually meant ironically and foreshadows a period of disorder and trouble. The omen feels appropriate given our current era of political and economic instability.  With the combination of continued trade tensions between the U.S. and China, slowing global growth, the re-emergence of hyperactive central banks and rising geopolitical uncertainty, things are a little more interesting than we would like.

Yet despite these forces of turmoil, both stock and bond markets have continued their steep ascent.  Most major stock indices are up double digits for the year, and even core bonds are up a surprising 8.5% for just the first nine months of 2019.  The third quarter did start to show some cracks, however, as smaller U.S. stocks and international stocks lost some ground even as large U.S. stocks and core bonds posted relatively strong performance.  The standout asset class for the quarter, though, was gold, as the proliferation of negative-yielding bonds has made the case for owning gold even stronger. The table below summarizes the third-quarter and year-to-date (YTD) performance for selected indices.

“But Why Is the Rum Gone?”

The 2003 film Pirates of the Caribbean: The Curse of the Black Pearl saw a motley crew of pirates (led by Johnny Depp’s Captain Jack Sparrow) hunting for treasure, but also with a running gag about the pirates’ desperation for more rum.  Investors today are thirsty for yield in a similarly desperate fashion.  While the precipitous drop in interest rates so far this year has resulted in strong price appreciation for bonds, investors are now asking themselves, “But why is the yield gone?”

The yield on 10-year U.S. Treasury bonds collapsed from 2.68% at the beginning of the year down to 1.67% by the end of the third quarter. The cause of the drop is mainly due to slowing global growth and international trade.  While these heightened risks have dented CEO confidence and business investment activity, U.S. consumers (accounting for 70% of the U.S. economy) have remained resilient in their outlook and spending.  The Federal Reserve seemed to err more on the side of concern, cutting rates twice during the quarter.  Significantly, global central banks are once again using monetary policy as a panacea for all problems.  Their re-introduction of unconventional monetary policies has resulted in record levels of negative-yielding bonds, with roughly 27% of global bonds sporting negative yields by the end of the third quarter.

How Can a Bond Yield Be Negative?

Negative interest rates are a remarkable and counterintuitive concept.  The only reason this concept exists is that central banks across the globe are desperately trying to stimulate their economies, and negative rates are a key part of their plan to force banks to increase their lending activity.  Historically, banks that chose to hold higher levels of cash reserves would make some positive return on those reserves.  However, both the European Central Bank and the Bank of Japan have set those reserve rates at negative levels.  The central banks hope that charging banks to keep their money idle will incentivize them to lend the money to businesses and consumers, thus stimulating their respective economies.

Negative rates on these bank reserves are one thing, but negative-yielding bonds are a different animal altogether.  In a normal environment, lenders receive interest on their loans as compensation for the default risk that they are taking on.  That rate of compensation varies, of course, depending upon the perceived level of risk.  A negative-yielding bond, on the other hand, is typically issued with zero percent yield and at a price above par. By the time the bond matures, the price will drop back down to par, ensuring that the investor who holds the bond to maturity will incur a loss.  A numeric example would be an investor who pays $102 for a bond yielding 0% that matures at a price of $100.  If that investor holds the bond to maturity, he or she will lose $2, resulting in an effectively negative yield or return.

Given the above, one may wonder who in their right mind would buy negative-yielding bonds?  There are a number of non-economic or forced buyers out there, such as European banks and index funds, which must invest in government bonds for regulatory or investment policy reasons.  In addition, speculative buyers may purchase these bonds to try and profit from potential price appreciation, but do not intend to hold these bonds to maturity.

Why Do Negative Bond Yields Matter?

There are potential consequences to this strange experiment with negative rates and yields.  The most obvious has been the steep appreciation in the prices of risk assets (e.g., stocks, bonds, real estate, etc.) as savers have been forced to take on more risk to maintain their lifestyles.  For example, the yields on bank CDs and Treasury bonds no longer meet most savers’ income needs so they are forced to seek higher-yielding returns in the stock market. This has led to a decoupling of asset prices from the underlying fundamentals and heightened valuations.  Also, with the proliferation of cheap debt, corporations have become over-leveraged to the point where many companies will be vulnerable to defaults when rates eventually rise.  Most importantly, however, we believe that these types of extreme policies have actually suppressed the very economic growth that central banks are trying to create.  With cheap debt comes the misallocation of capital.  What that means is that weak companies are able to survive much longer than they should be able to, which in turn takes away growth opportunities from stronger companies.  The end result is that weak companies that should go out of business end up puttering along, thereby keeping stronger companies from flourishing as they should.

Unsurprisingly, there is no convincing evidence that setting short-term policy rates to zero or below and buying large amounts of longer-term bonds has stimulated the economies of Europe and Japan.  These policies were effective short-term tools in the aftermath of the Great Recession to stabilize financial markets.  However, the two long-term drivers of any country’s economic growth are productivity and the growth of its labor force.  With productivity stagnant over the past decade, population growth has become even more important than in decades past.  Population growth trends, however, are negative in both Japan and the developed European countries.  In the U.S., structural changes within the economy and a slowing immigration trend have also combined to reduce growth potential relative to the past half-century.

There is no way to know how long traditional stock and bond markets will continue to run without any apparent regard for the fundamentals.  While it seems like an obvious decision not to invest in negative-yielding debt, it is somewhat less obvious where to invest given the heightened levels of risk and the wide ranges of return scenarios with more traditional asset classes.  In view of this, we have chosen to position our client portfolios away from traditional core bonds and focus instead on specialized segments of the bond market in an attempt to generate reasonable returns regardless of what happens with interest rates.  We have also chosen to trade market risk for illiquidity in a portion of client portfolios as these less liquid investments are often driven by factors beyond just economic growth and interest rate movements.  In interesting times such as these, the more true diversification and consistency we can incorporate into portfolios, the better we sleep at night.

Please do not hesitate to contact your Morton Capital wealth advisory team if you have any questions or would like to review your portfolio or financial plan in more detail.  As always, we appreciate your continued confidence and trust.

Morton Capital Investment Team

 

 

Disclosures

This commentary is mailed quarterly to our clients and friends and is for information purposes only.  This document should not be taken as a recommendation, offer or solicitation to buy or sell any individual security or asset class, and should not be considered investment advice. This memorandum expresses the views of the author and are subject to change without notice. All information contained herein is current only as of the earlier of the date hereof and the date on which it is delivered by Morton Capital (MC) to the intended recipient, or such other date indicated with respect to specific information. Certain information contained herein is based on or derived from information provided by independent third-party sources. The author believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information. Any performance information contained herein is for illustrative purposes only.

Certain private investment opportunities discussed herein may only be available to eligible clients and can only be made after careful review and completion of applicable offering documents. Private investments are speculative and involve a high degree of risk.

The indices referenced in this document are provided to allow for comparison to well-known and widely recognized asset classes and asset class categories. Q3 returns shown are from 06-28-2019 through 09-30-2019 and the year-to-date returns are from 12-31-2018 through 09-30-2019.  Index returns shown do not reflect the deduction of any fees or expenses. The volatility of the benchmarks may be materially different from the performance of MC.  In addition, MC’s recommendations may differ significantly from the securities that comprise the benchmarks.  Indices are unmanaged, and an investment cannot be made directly in an index.

Past performance is not indicative of future results.  All investments involve risk including the loss of principal. Details on MC’s advisory services, fees and investment strategies, including a summary of risks surrounding the strategies, can be found in our Form ADV Part 2A. A copy may be obtained at www.adviserinfo.sec.gov.