Climbing Out of the Hole
As of June 8, 2020
Brian Collins, CIO, Harbor Capital Advisors, Inc.
Digging Holes does not Build Character
In the young adult novel Holes, by Louis Sachar, the warden of a youth corrections facility located in a desert orders young men to dig a six-foot-deep hole every day. When asked by concerned officials why he makes them do this, he responds digging holes builds character, which he believes the youths need to properly reform. He’s secretly having them dig holes for treasure he believes is buried somewhere in the desert. Relatively few people like digging holes, particularly in a hot desert as in this case; it is back-breaking work that promises no reward for those doing the hard labor. For most people, digging a hole every day would not be a character-building exercise of choice.
During the late February and March pandemic fueled market collapse, many investors felt like they were digging a hole every day in the hot desert with little relief, just as it was for those young men. In the novel, the warden’s scheme ends when two boys secretly found the buried treasure and alerted the authorities. The days of “building character” were over. We believe the recent intervention by governments and central banks in late March to attempt to address the expanding economic crises and arrest market declines helped investors who found themselves in holes they had no interest in further digging. This unprecedented level of government intervention created additional risks and uncertainties, making it difficult to forecast the likely path of recovery. But the immediate effect on the markets was significant.
The Best Thing to do When Stuck in a Hole is to Stop Digging
Since late March, markets and investors have stopped digging deeper holes and have started climbing out towards the long path to recovery. The first stage has been a sharp bounce led by many of the drivers that were leading the market before it collapsed. How markets progress from this point forward will provide some insights on how lasting the impacts of the pandemic will be on economies and investors. It is very likely that at some point markets will fully recover from their steep decline, though when and how remains unknown. We believe the road ahead is long, will not follow a straight path, and will have switchbacks and reversals. As a result of the significant stimulus efforts, we think markets advanced further than fundamental support and are not pricing in the significant risks that remain. However, we are cautiously optimistic that equity markets will likely recover and be less driven by the small subset of stocks that have carried the load for several previous months. At a minimum, it appears the digging has stopped for the time being, and the hole is steadily being filled.
From its peak on February 20th to its low on March 23rd, the S&P 500 declined by 33.8%; one of the sharpest and fastest declines on record. From that low point to the end of May, the Index has rallied 36.6%. However, due to the compounding effect, markets have not filled in the hole completely. For every shovel full of dirt that was removed from the hole when digging, more than a full shovel goes into filling the hole before it gets back to the prior level. The return of the S&P 500 from February 20th through May 31st was -9.6%. Adding in the positive returns realized prior to February 20th, the S&P 500 was down -5.0% on a YTD basis through the end of May. So, the hole is a little less deep but still requires more work. For the S&P 500 to return to its 2020 high point return of 5.1% by the end of the year, the Index needs to generate a return of 10.6% over the next seven months. This is not an insurmountable task, but after the rally of 32% over the last nine weeks, there are questions about how many arrows are left in the quiver to potentially hit this target. The story for the MSCI EAFE is a bit bleaker. The Index had a small gain of 1.0% from the start of the year through January 19th. At this point, the Index would likely need to return 17.8% over the next seven months to overcome its year-to-date performance shortfall of -14.3% and get back to its high point. Setting a full recovery target date by the end of 2020 is arbitrary and we believe overly optimistic. The recovery may take longer and will be challenged by many factors and events that are still likely to occur. Looking back to the Great Financial Crisis in 2008/2009, it took almost 4.5 years before the S&P 500 exceeded its prior level achieved before the crisis began. It is hard to predict when the S&P 500 will recover fully from the pandemic.
As we look ahead, we are encouraged by a few developing positive signs observed in May:
- Greater market breadth
- Continued strength in smaller cap stocks,
- Less divergence between growth and value (although growth stocks continued to outperform)
- A narrow gap between the S&P 500 and MSCI EAFE
- Better performance from sectors (IE: Industrials, Materials, and Energy)
Acknowledging that one month does not make a trend, it’s important to remember the need to stop digging the hole before starting to get out of it. We believe that if a number of these conditions persist as economies and markets slowly recover from the effects of the pandemic, there are increasingly attractive opportunities for active managers to add value. Managers have been challenged by the narrow concentration of the market leading into, during, and initially coming out of the pandemic period. We believe a broader market with lower levels of correlation between stocks provides more opportunities for active managers to demonstrate their skills and potential to add value.
A Steady Eye on Starting to Climb Out of the Hole
In discussions with our subadvisers, we note the management teams of companies and remain highly concerned about the near- and long-term impact of the pandemic on their businesses. However, our subadvisers also find that management teams are adapting to the new environment. In some cases, adapting means shifting business strategy and reallocating resources into the most productive parts of their businesses. For other companies, management is making the hard decisions that will hopefully enable weathering this period of uncertainty and building toward growth as conditions improve. In both instances, we believe active managers can differentiate between the winners and losers. Whether in credit or equity markets, seasoned analysts and portfolio managers who have experience evaluating businesses during periods of stress have the potential to find attractive new opportunities while avoiding the potential unknowns below the surface. We believe our diverse subadvisers have the skills to navigate the challenging times ahead.
Focus on a Foundation for Growth
We continue to advocate for maintaining a longer-term investment horizon and allowing investment strategies to perform over time managed by our talented subadviser partners. We know that challenges lie ahead and any market recovery takes time. There will be setbacks that will test the market and investor commitment. We believe it will continue to be important for investors to:
- Stay disciplined
- Focus on long-term investment goals and plans
- Make prudent investment choices
As we move forward, we think investors will recover from the heat and pain of this spring’s desert full of holes. For now, we appear to have stopped digging the hole and we and our subadvisers are doing our best to continue filling it in to support a foundation for future growth.
Past performance is no guarantee of future results.
The information shown relates to the past. Past performance is not a guide to the future. The value of investment can go down as well as up. Investing involves risks including loss of principal.
The views expressed herein are those of Harbor Capital Advisors, Inc. investment professionals at the time the comments were made. They may not be reflective of their current opinions, are subject to change without prior notice, and should not be considered investment advice.
The S&P 500 Index is an unmanaged index generally representative of the U.S. market for large capitalization equities. This unmanaged index does not reflect fees and expenses and is not available for direct investment.
The MSCI EAFE (ND) Index is an unmanaged index generally representative of major overseas stock markets. This unmanaged index does not reflect fees and expenses and is not available for direct investment.