October 2020 Economic Commentary

10.15.20 Jesse Ellington, III

Lessons from a Black Swan

Hopes are hanging on a new stimulus bill, election risk has been pushed to the side, liquidity is still in charge, valuations are stretched and the volatility we witnessed in September seems to be dissipating. Value stocks recently saw one of their best weeks in years, telegraphing a strong recovery, but we are skeptical. Whether this is yet another “head fake” and investors instead pour back into Growth, or they stick with Value will play out over the next three months. This is the kind of whirlpool that can both frustrate asset managers and also lead to bad decisions. We have high conviction that there is still a disconnect between the economy and the stock market.

Pockets of opportunity still remain. We have been spending a significant amount of brainpower in trying to find alternatives to fixed Income without adding volatility to our portfolios. Two weeks ago we added a diversified utility ETF to our Alternatives allocation, which has paid off handsomely in the short term. With a yield around 4%, this offers an attractive income stream, while providing some defensiveness relative to broad-based equities. In addition, utilities are a “back door” alternative energy play. No matter what new or existing green power solution is used moving forward, utilities will provide the delivery mechanism to both businesses and consumers.

Pivoting to how we are handling risk management in this uncertain environment, I recently re-read one of my favorite books, The Black Swan, which focuses on events that lie outside of the realm of possibility but happen anyway. The COVID-19 pandemic and the historic global shutdown is a clear example of a black swan event. As stewards of capital, it’s important not to fall into some of the traps that are shaped by both our historic biases and ego-driven linear thinking.

When the pandemic broke out in China, we were relying on past experience to give us comfort, not only in the fact that the virus would not be life threating and could not reach our shores, but also that our government reaction would be similar to other virus outbreaks in the past. This “narrative fallacy” set us up for early failure in recognizing a full set of possible outcomes including a global pandemic and the subsequent economic shutdown. Our current situation provides the best example of the “confirmation bias”.

Most market prognosticators think both fiscal and monetary policy action will get us out of this crisis—it has always worked in the past and therefore it’s going to work again. Unfortunately, there are still too many unknown factors that could go against this narrative. Will we see inflation, currency debasement, credit downgrades and defaults, or could we see PE multiples twice the level of historical averages? All of these outcomes, and many more, are entirely possible, and that is why we are constantly re-engineering our asset allocation to take advantage of multiple emerging scenarios. Our primary focus continues to be building portfolios that hold up over multiple market cycles, but we are keeping one eye cocked for that Black Swan floating by.

Please let me know if you have any questions via phone at 804-774-2087 or email at Jesse.Ellington@middleburgfinancial.com.

Disclosures:
Past performance quoted is past performance and is not a guarantee of future results. Portfolio diversification does not guarantee investment returns and does not eliminate the risk of loss. The opinions and estimates put forth constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

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