Rather, this is just an excuse to write to you to tell you about our thoughts on the market. It would be a bit of an understatement to say this has been a wild week. In 6 trading days, the market has gone from an all-time high to a 15% correction. That is unprecedented… literally…it is the quickest the market has gone from record high to >10% correction. Also unprecedented is the performance on consecutive days. As of this writing, this week has included the #1 largest drop ever (in point terms, not % terms) for the Dow (Thursday), #3 (Monday), and #4 (Tuesday). That said, in percent terms, none of these days are even close to the top 20 list. But as a week, it would rank 4th worst all-time, behind October, 2008, and two weeks in the Great Depression. Even the week including Black Monday in 1987 was not this bad.
There are many other ways we could describe the carnage, but perhaps the best analogy is the board game “Chutes and Ladders.” Notice the following 1-year chart of the S&P 500… I think we landed on the dreaded 87 (no pun intended to relate to 1987…87 is the actual spot on the board game which features the longest drop).
There are a few things to keep in mind while trying to assess the landscape and divine how much more carnage is to come:
- The S&P 500 was +30% last year. Since the beginning of last year, the market is still +19% (as of this morning).
- The “feel” of the market in late 2019 and early 2020 was eerily similar to that of late 2017 and early 2018. While investors didn’t display a lot of outright ebullience, there was a lot of complacency and melting away of fears. Even as the coronavirus spread to the U.S., the market kept climbing in the first 19 days of February. You might recall, the market fell quite suddenly in February, 2018, too.
- Stocks have been pretty darn expensive for a while in absolute terms. The higher stocks are, the more volatile they will be when met with a great uncertainty such as this. But compared to bonds, stocks have been cheap this whole cycle, and continue to be.
As we try to make sense of where the market might go next, the factors on which we normally focus—the fundamentals (earnings, dividends, cash flow) of our stocks and valuations—don’t matter whatsoever. When panic trading rules the market, technical indicators become a lot more useful. This is fear of the unknown. As you know, we’re not technical traders, but we do keep an eye on a few. These charts are from Strategas, fresh this morning:
VIX Index (measure of volatility)
These have all reached levels that have marked the bottom of past corrections (with the possible exception of the put/call ratio), like in Dec 2018, Feb 2018, Jan 2016, Aug 2015, and Sep 2011. That doesn’t mean anything for certain, but it does give an idea of the market’s “temperature” right now….that the market is utterly gripped by fear.
The news yesterday that seemed to unravel the markets was that health authorities can’t figure out how a patient in California became infected. The way this epidemic becomes a pandemic is that the incubation period is so long, so who knows who even has the virus and is showing no symptoms yet? To get to worst-case scenarios, like we all catch the virus eventually, the power of repetitive extrapolation is required and a lot has to go wrong. There are some good reasons to believe it won’t. First, the number of new cases in China has been slowing for a while. This is probably due to China’s travel restrictions and quarantines, which seem to have worked to prevent the spread of infection. Most other countries have yet to impose these.
Second, anti-viral medicine, vaccines, and spring are all on the horizon. That said, there’s no certainty that any of the medicines will work as hoped. And as for whether spring will eradicate the virus (or send it to the Southern Hemisphere), this is generally true for viruses, because they spread much better in cool, dry conditions. But again, there is no certainty that this virus is susceptible to the same tendencies as other viruses like influenza.
Finally, while there are fears that the virus will morph into some killer bug, viruses tend to weaken over time. Even the Spanish Flu did, and in fact that’s how the Spanish Flu ended…man did virtually nothing to stop it. The unique feature of that virus is that the death rate for young adults was far worse (estimated 8-10%) than for infants and the elderly. The death rate from coronavirus is now estimated to be 2%, which is still multiples above that of influenza (0.1%).
So how does this impact the stock market? As we all know, investors are emotional people, prone to fear and greed. We are taught that a stock price represents the latest set of information about a company and how the market is valuing it. But trading days like those of this week confirm to us that markets aren’t exactly efficient at processing information.
Obviously, investors are concerned how the virus will impact the economy. It should be mentioned that the market has been on Recession Watch for 11 years, ever since we emerged from the last one. We should have had 4 or 5 recessions since the financial crisis, if you had believed the consensus. Whether we have a recession or not depends entirely on how widely the virus spreads and, more importantly, how quickly it is eradicated. We believed at the outset of coronavirus that SARS, MERS, avian flu, and bird flu provided a realistic path. That doesn’t look like a safe assumption anymore, simply because of the long incubation period.
We know that this will continue to spread for a while, and thus impact the economy. While Chinese factories have been starting up, travel restrictions still largely in place have hampered the flow of workers back to the cities in which they work (especially for those who traveled home for the Lunar New Year), so production is ramping back up slowly. Given how interconnected global supply chains are, this factor alone will greatly impact the global economy in coming months. If a pandemic ensues, and travel and work are restricted in the U.S., that would deepen the recession.
The variable that matters to all of us is how the market processes this. In our minds, this will run its course eventually, and businesses will eventually be fully functioning again. Pent-up demand will lead to excessive growth for a time, to make up for the lost output during the contagion. But first there will likely be a period where the economy contracts, whether it’s in weeks or months or quarters. Will the market forgive companies as they guide down earnings estimates, which they have now begun to do? We believe they will, if only because the visibility to a recovery from the recession is very high. By contrast, the housing bust morphed into a financial crisis, into a banking system crisis, and into a really nasty recession. Companies sacked 10 million employees in the U.S. alone. Companies this time will likely be very reluctant to let people go, fearing they won’t get them back when growth returns.
For now, we are waiting to see what comes next, but along the way, we will opportunistically make adjustments if they make sense, like if asset allocations veer from targets. Plus, we also believe our higher-quality stocks will hold up better than the rest of the market, as they have this week. If you have any questions, please don’t hesitate to give us a shout!