In every investor’s lifetime there are dozens, if not hundreds, of global events that test both an individual’s resolve and their confidence in the stock market’s resilience. The reaction to these events often make-or-break the long-term benefits accrued from stock market participation. In light of recent market action, it behooves us to take a moment to reflect on the current situation and the lessons history may offer for how to move forward.
The current event of note is a virus that is now officially referred to as COVID-19, an abbreviation for “coronavirus disease 2019.”
TELL ME ABOUT RECENT MARKET ACTION
In short, this past week was not particularly pleasant to stocks. Since hitting all-time highs on Wednesday, February 19, the S&P 500 is now roughly down a quick and efficient 13%. This type of extreme market movement isn’t seen often, and the turnaround brought us back to the October 2019 levels of 2954.
WHY A CORRECTION NOW?
Some may argue that the stock markets were ripe for a pullback or correction simply based on valuations. The fourth quarter of 2019, along with the beginning of 2020, brought the markets to fresh all-time highs, with a record-high closing price at 3386. According to FactSet, the peak forward 12-month Price-to-Earnings (P/E) ratio for the S&P 500 was 19. This P/E represented analyst Earnings Per Share (EPS) of $176 in calendar year (CY) 2020 and $196 in CY 2021. For context, the historical averages for forward P/E ratios on the S&P 500 are: five-year (16.7), 10-year (14.9), 15-year (14.6), and 20-year (15.5). Even at 19.0, though, the ratio was well below the 20-year peak of 24.4 on March 24, 2000. Furthermore, it is imperative to remember that the market rarely trades at the average and there are many more metrics besides P/E that inform a determination on pricing. As it is often said when investing, valuation doesn’t matter – until it finally does.
The past few weeks have brought to light increased uncertainty regarding the “E” part of P/E. Risk assets have sold off sharply in recent days as the virus’s rapid spread beyond China dashed hopes for a quick resolution and compelled investors to hurriedly reprice expectations for reduced global economic growth and impaired corporate earnings. The outbreak of the coronavirus represents a significant shock to both supply and demand in China. Widespread restrictions on travel and other public-health measures have hurt the service sectors of the economy, while many factories have been forced to close as authorities seek to contain the epidemic. A Bloomberg report suggested the Chinese economy was operating at about 50% – 60% of capacity in the week ended Friday, February 21. We believe it’s quite likely that Chinese real Gross Domestic Product (GDP) growth will contract significantly in the first quarter of 2020 in quarter-on-quarter terms—the first such instance in China’s history of reported quarterly data—though it’s uncertain whether official government data will reflect this.
Assuming factories reopen and production returns to full capacity at the pace currently planned by authorities without creating new rounds of infections, business and consumer activity may snap back sharply. Full-year 2020 economic growth in China appears very likely to fall short of 2019’s 6.1% pace, in our view; a meaningful slowdown could translate into a considerable hit to global growth.
Companies across industries and geographies have begun warning analysts that the effects of the COVID-19 outbreak are likely to be evident in first quarter and full-year 2020 financial results, while also acknowledging that quantifying the impact remains difficult at this stage. Companies with a global presence, like Apple and Mastercard, have suspended earnings guidance, cueing Wall Street to bring down earnings estimates for the first quarter, second quarter, calendar year 2020, etc. It appears that quarter one of 2020 will be the asterisk quarter.
While the stock market performed well in 2019, it was on the back of P/E multiple expansion of 30%, which means that market performance was based on paying 30% more for the same dollar of company earnings. The 2020 year was supposed to be that of a corporate earnings recovery, predominately due to diminishing trade tensions, strong consumer spending, and accommodative monetary policy. These all remain quite real, and the US has started the year with solid economic data, but an economic slowdown in China could push out the recovery a bit later than originally expected. From a macro-economic point of view the question is about how this will impact the US economy over the coming year. The risk is that the earnings bottom for the S&P 500 is ahead of us, not behind. The baseline is that lower earnings in the first half of the year should be made up by a strong rebound in the second half of the year with payback from lost months. Current Earnings Per Share are at $161, and we will need to carefully monitor how expectations evolve.
CAN WE PAUSE TO TALK ABOUT PUBLIC HEALTH?
I think that it is also important to recognize that we actually face two concurrent issues in the discourse. We have thus far touched on one issue, the economy and markets. The other issue is about public health. They won’t necessarily correspond with each other, but it is important to stay informed on both.
Let’s take a step back and say that we would like to express our sympathy for everyone affected by the virus.
A total of 97% of the global cases of COVID-19 are still within mainland China, despite the virus having been around since at least December. Most (81%) of global cases are within Hubei province, the epicenter of the outbreak. Shanghai, a city of 24 million people, has experienced 335 cases. Beijing, with a population of 22 million, has 399 cases. The vast majority (95%) of all global fatalities have taken place in Hubei province. The fatality rate in Hubei is at 2-4%, whereas the fatality rate is at 0.7% for the rest of China. This is likely due to the overwhelmed Hubei health care system. The global case-fatality rate is 3.3% (again, due to the hefty Hubei presence). Importantly, 80% of COVID-19 cases in China are considered to be mild.
As of Friday (2/28/20), there were 60 cases of coronavirus in the United States, the bulk of which were from one cruise ship. All but one could be traced to either a cruise ship or a person or spouse coming from China. We should expect more, but for now, it seems to be spreading slowly here.
According to a recently circulated district update from Orange County Assemblyman Steven Choi, “The health risk from COVID-19 to the general public remains low at this time. While COVID-19 has a high transmission rate, it has a low mortality rate.” We encourage you to review the full letter for more information of how the State of California is responding.
For comparison purposes, the severe acute respiratory syndrome (SARS) coronavirus appeared in 2002-2003, and had a fatality rate of about 10%. The Middle East respiratory syndrome (MERS), a coronavirus that was first identified in Saudi Arabia in 2012, had a case-fatality rate of about 35%. Ebola virus disease (EVD) is rare, but has an average case-fatality rate of about 50%. According to the US Centers for Disease Control and Prevention (US CDC), there have been at least 29 million flu illnesses for the current influenza season in the US, 280,000 of which resulted in hospitalizations and 16,000 of which resulted in deaths. Globally, however, COVID-19 has caused a total of 2,618 deaths (see “Coronavirus Disease 2019 and Influenza” report by JAMA Network).
Another phrase that has recently been thrown around is “pandemic”. By definition, a “pandemic” is a disease that has spread globally. The term does not describe the severity of the disease, only its geographic spread. The most recent pandemic was in 2009 with the H1N1 virus, also known as “swine flu.” H1N1 was first detected in California, on April 15, 2009 and was designated a pandemic through August 2010. The US CDC estimated that 151,700 – 575,400 people worldwide died from H1N1.
The pace of scientist innovation is encouraging. Last week, only a few US labs could test for the coronavirus. As you read this, 93 labs will already have testing facilities. Bedside diagnostic technology is forthcoming, too, as 70 companies are in development. The FDA is changing its procedures to allow confirmation testing at labs other than the CDC’s main headquarters. This will ease concern by allowing the quick separation of actual COVID-19 cases from common colds and flu. It is expected that the number of labs which can administer tests will increase dramatically over the next few weeks, as new testing kits will come online. There is already an experimental drug designed to treat COVID-19 moving toward first phase clinical trials. Astonishingly, it has only taken three months for this response in 2020, whereas it took 20 months to respond to SARS in 2002-2003 – a testament to advances in drug technology. There is also a meaningful probability that vaccines will be available by the end of the year/early next year, which means we may all be getting an annual vaccine for COVID-19 along with the flu shot. This may seem counterintuitive, but in a certain sense, COVID-19 provides a massive wake-up call to the world for enhanced attention to outbreak preparation.
We note that knowledge of this new disease is incomplete and evolving daily. While we are hopeful that the worst of the COVID-19 outbreak is behind us, we don’t know what the future holds. We are not virologists, but the current opinion is that there are two sanguine outcomes: 1) the virus spreads to lots more people, most cases are mild and we learn to live with the threat; and/or 2) public health efforts and less togetherness during warmer months cause the virus to die out.
IS THIS THE 66TH MARKET PANIC ATTACK?
Economist Ed Yardeni, PhD, of Yardeni Research has previously identified 65 “panic attacks” during the current bull market, all of which were followed by relief rallies. In essence, all panic attacks have been buying opportunities. Dr. Yardeni believes the coronavirus may have the dubious honor of being the 66th. The firm considers the impact of the virus on global health and the world economy to be no more dangerous than previous outbreaks such as SARS in 2003 and the MERS outbreak in 2012.
It is still too early to tell if this is a panic attack. We do know that these quick dips in the market and proclaimed “reasons to sell” have been met with a V-shaped recovery shortly afterwards. Recent examples include: The Flash Crash in 2010, the European Debt Crisis in 2011, the London Whale in 2012, the Taper Tantrum in 2013, the Ebola Scare in 2014, the Chinese Yuan in 2015, the Oil Crash in 2016, Brexit in summer and the Trump Whipsaw later that fall of 2016, the Trade War’s onset in 2017, the ill-advised Jerome Powell remarks in 2018, and so on.
Data from First Trust shows us the historical performance of the S&P 500 Index during several epidemics over the past 40 years. Over a 38-day trading period during the height of the SARS virus back in 2003, the S&P 500 index fell by 12.8%. During the Zika virus, which occurred at the end of 2015 and into 2016, the market fell by 12.9%. There are other examples, but they all passed, and the market recovered and hit new highs. More specifically, the S&P 500 was positive in 11 of the 12 cases reviewed, with an average price return of 8.8%. The 12-month change was even more encouraging, with an average price return of 13.6%.
WHAT’S THE PLAYBOOK?
Historically the market's reaction to epidemics and fast-moving diseases is often short-lived. Nevertheless, volatility is likely to persist as investor attention is decisively shifted away from fundamentals (revenues and earnings) and towards the unknown (headlines). Virus outbreaks, while scary, have historically been worse on human psychology than the economy. At this time, it is possible that the fear of the coronavirus as a global pandemic is arguably greater, for now, than the actual economic impact it is likely to have. Past performance, of course, is no guarantee of future results, but this historical data does give confidence that if COVID-19 is largely brought under control in March, then economic activity can largely return to normal. While first quarter macroeconomic and earnings numbers would be unflattering, the full year growth rates would likely be reasonable.
Over the next few days, or maybe even weeks and months, people are going to be looking for signs of a stock market bottom. It may bounce from here with a bang, a rally and retest, or with a fizzle. One way or another, this too shall pass.
We are using this time to monitor news flow, further review our stock position wish list, and determine entry points for our favorite companies whose value proposition is largely unchanged and at now available at reduced pricing. As part of our investment strategy, in conjunction with the use of tax loss harvesting, the team aims to keep adequate cash available for these opportunities. This means that we are not forced to sell and can be fully invested when the market comes back.
KNOCK KNOCK, WHO’S THERE… DIVERSIFICATION
As a stock market investor, it becomes clear that surprises happen often and from unexpected places. These times of heightened volatility in the stock market can then translate to increased emotional volatility. In other words, fear begets fear. In this case, it’s not that you shouldn’t be concerned about the economic reality of how the spread of a virus may impact business, but rather that you resist your instinct to flee equities.
The key is to plan in advance for these times of raised concern through the use of diversification – by asset class, region, and strategy – in a way that lines up with your specific investment objectives and timeline. While stocks were hit hard this week, they have been highly profitable in almost any medium- to long-term time horizon and will likely continue to be. In the meantime, the bonds in the portfolio did their job of hedging by increasing in value and dampening overall portfolio volatility. The written call options provided extra income to offset stock turbulence. The gold, which has low correlation to stocks and bonds, shined with its defensive qualities. The cash-on-hand for your emergency fund, near-term expense needs, and investment “dry powder” is unscathed and at the ready.
If you are an accredited investor, there may be other investment options available that are non-correlated to the stock market. The appropriateness of such an investment likely depends on your specific financial situation and we are happy to discuss further with you at the next meeting.
As we all intuitively know, you need to have insurance protection in place before you actually need it. Diversification and prudent asset allocation is the insurance needed for long-term investor success. The recent turbulence only underscores the benefits of seeking to build resilient portfolios that help protect against the permanent impairment of capital while pursuing attractive real returns across economic cycles and capital markets conditions.
EVERYBODY DESERVES A FINANCIAL ROAD MAP
If you are unclear about whether or not your current investment strategy fits your risk tolerance, time horizon, and goals, know that we are here to discuss further. This may be the time you need a trusted financial professional most and we are happy to conduct a complimentary Financial Road Map update. During most volatility, we typically advise clients to “stay the course,” and that generally proves to be the best course of action. In times like this, however, it’s easy to question conventional wisdom. Remember that the Tellone Financial Services team is here to help you and your family during this time. Whatever decisions you make, please allow us to support you through them and feel free to reach out to us with any questions or concerns.