The Rules of Navigation Never Navigated a Ship ~ Thomas Reid

There is a pocket guide on my shelf I picked up twenty years ago called The Worst-Case Scenario Survival Handbook. It details the necessary action steps to take when confronted with unlikely yet life-threatening situations. . . imagine things like stuck in quick sand or fending off a shark or what to do if your parachute fails to open. All of the information in the book comes from experts in the situation at hand. Their advice seems reasonable given they survived and there is a large enough sample size of others who have successfully dealt with the same scenario.

But what do you do when dealing with a new threat without a playbook? One where there is no previous experience – like a zombie approaching? Do you run, offer a beer, or pull out the kitchen knife? No one knows. All you can do is build a framework using knowledge, experience and new data as it becomes available.

Similarly, Wall Street offers scores of playbooks – what to do during times of rising inflation or economic recessions or liquidity crunches. We have worked through or studied those markets at length to better prepare ourselves as asset managers. What do we do then when dealing with a new threat? One where there is no previous experience – say like a medical crisis, an economic cessation and a liquidity emergency happening simultaneously globally? The answer is the focus of this quarter’s letter – to share with you our framework and our plan going forward.

As a backdrop, the first half of 2020 contained an all-time high for stocks, the deepest recession since the 1930s and the sharpest bear market drop on record, followed by a market rally that included the fifth-strongest quarterly gain since 1950. In total, the S&P 500 finished the second quarter up 515 points, or +20%, to 3100 – its biggest percentage gain since the last three months of 1998. The Dow Jones Industrial Average added 3895 points, or +18% – its best quarter since 1987. The rally has cut the indexes’ losses for the year to 4% and 10%, respectively. Further:

• The economic picture remains bleak. Nearly 20 million jobs have been lost since February. Unemployment went from a 50-year low (3.5%) in February to the highest level since the Great Depression (14.7%) in April, reflecting the abrupt and widespread economic shutdown. Retail sales are far below pre-pandemic levels and manufacturing activity in the U.S. also contracted, albeit at a more gradual rate.
• The Federal Reserve announced a policy of quantitative easing forever and became a massive backstop for the financial markets and the economy with truckloads full of cash. The Fed actually started its campaign on March 15, when it announced a lowering of federal funds rate by 100bps to zero. Since then, the Fed’s security purchasing programs have pushed its balance sheet by $2.5 trillion to a record $7.1 trillion. Its holdings of Treasury securities increased $1.6 trillion over the same period to a record $4.1 trillion.
• Congress authorized three pieces of legislation to address the outbreak, bringing the total amount of already-passed economic support to $3.6 trillion – much of it aimed at getting cash into people's hands immediately to help them pay their bills and buy groceries. So far, the biggest aid package approved by Congress was the CARES Act which accounted for approximately $2.7 trillion of the spending. It called for sending direct payments to most Americans, expanded unemployment benefits, and included emergency grant and loan programs for small businesses.
• Finally, the medical crisis has evolved but not necessarily improved. Active cases and new diagnosed cases hit records in the United States on June 30 even as some would argue that increased testing and lower death rates prove better management. Further, 23 companies have stepped forward with plans to develop vaccines or treatments but clinical trials are still in process with unknown outcomes.

So how do we manage market exposure and stock selection models during this time? We rely on knowledge, experience and data as it comes available. At the time of this writing, our US tactical models are 68% invested and 32% in cash. Our analytics suggest we will sit in the market channel between S&P 500 3,200 and 2,800 as bouts of hope and fear consume investors week to week. Our position is guided by over 13 new data sources we have added to our core models. We have purchased or accumulated data sets covering real-world metrics like infection rates, restaurant bookings, bankruptcy filings, public transit and credit card usage as well as mobility and lockdown data. 

Given our approach, we are optimistic that better investment opportunities lie ahead. This framework kept us adding equity positions in early April when we were 75% invested and then subsequently reducing exposure during some of the advance in May when we hit our exposure low of 61% on 5/13. We were and continue to actively balance risk and reward along the way given the best set of inputs and signals we can uncover and I’m proud of our effort here.

Stock selection, however, continues to amaze me. Even with great market exposure analytics in order to keep up with the market we would need to place over 23% of our clients’ capital into the five stocks (MSFT, AAPL, AMZN, GOOGL, and FB) that have dominated all of the investment gains this year. If you stripped them out, the market would be down closer to -10%. Diversification, according to Nobel prize winning economist Harry Markowitz, is an investor’s best friend over long periods of time ‒ a risk reducer and an investment tailwind. However in the recent past, like many things right now in the world, this is upside down and reminds me of the market in 2000 when investors similarly could not own enough of Enron, GE, and CSCO.

Thomas Fuller once said “Vows made in storms are forgotten in calm” and nothing better captures this saying than the “stay at home” stocks in the current “storm”. People seem to have forgotten the 2000-2002 market and that the price you pay for something matters. . . paying 502 times earnings to own a stock like Zoom is a fantasy but price momentum is all the market cares about right now. Zoom has echoes of Etoys.com or Pets.com during the late 90’s.

We continue to conduct additional research and will share with you more about this subject this quarter. Understanding this phenomenon is an important topic. The biggest stocks in the market are also the best performers. While the median stock is -11% YTD, the top 10 are +9.6%.

While I’ve included a lot of information here, it’s important to convey that especially in these complex times we operate strategically on a myriad of fronts. As always, thank you for your business. We have worked hard as a team – from investment and advisory to trading and operations – to deliver top advice and uninterrupted service during these challenging times. My thanks go to my amazing colleagues here at NorthCoast and my hope is that this letter finds you and yours healthy, safe, and doing the best you can. Things will get better. Bumpy but better.  

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Important Disclosures

The information contained herein has been prepared by NorthCoast Asset Management LLC (“NorthCoast”) on the basis of publicly available information, internally developed data and other third party sources believed to be reliable. NorthCoast has not sought to independently verify information obtained from public and third party sources and makes no representations or warranties as to accuracy, completeness or reliability of such information. All opinions and views constitute judgments as of the date of writing without regard to the date on which the reader may receive or access the information, and are subject to change at any time without notice and with no obligation to update. This material is for informational and illustrative purposes only and is intended solely for the information of those to whom it is distributed by NorthCoast. No part of this material may be reproduced or retransmitted in any manner without the prior written permission of NorthCoast. NorthCoast does not represent, warrant or guarantee that this information is suitable for any investment purpose and it should not be used as a basis for investment decisions. © 2020 NorthCoast Asset Management LLC.

PAST PERFORMANCE DOES NOT GUARANTEE OR INDICATE FUTURE RESULTS.

This material should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or investment products or to adopt any investment strategy. The reader should not assume that any investments in companies, securities, sectors, strategies and/or markets identified or described herein were or will be profitable and no representation is made that any investor will or is likely to achieve results comparable to those shown or will make any profit or will be able to avoid incurring substantial losses. Performance differences for certain investors may occur due to various factors, including timing of investment.  Investment return will fluctuate and may be volatile, especially over short time horizons.

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