Stocks fell sharply for the second straight day, extending losses since recent market highs to close to 8%. 62% of the S&P 500 is now in correction mode, meaning that they are down at least 10% from their highs. Overnight there have been no signs of buyers around the globe as nervousness related to the coronavirus spread.
Stocks had already erased early morning gains yesterday when health officials around the world warned that the spreading of the virus likely cannot be contained. A pandemic is a possibility. While the U.S. has seen little evidence of the disease or its impact yet, the same health officials said it was inevitable that the virus would strike our nation. The only questions were how hard and for how long.
I caution that world health organizations like the WHO and the CDC here in the U.S. will always err on the side of caution. They want to be as prepared as possible and they want citizens to exercise as much caution as they can. The results overseas have been almost total lockdown in some affected areas. From an economic perspective, that is scary.
Thus an 8% correction, one that could extend significantly before it is over, isn’t irrational. With that said, we are at the point in this disease cycle where emotion takes over and rational behavior takes a back seat. We saw this with SARS almost 20 years ago, and we even saw it with Ebola more recently. But these natural disasters always pass. This one will too. To be sure, there will be lots of short-term damage. An epidemic could cause a short-term recession. Think back to 2001 and the 9/11 bombings. Everyone went into freeze mode for a couple of months before life as we knew it resumed. To an extent, the same will happen here. If enough cases happen worldwide, manufacturing output will decline, and parts shortages will emerge. Travel, particularly leisure travel, will drop in a meaningful way. Shoppers will stop roaming malls. People will opt to eat at home and stay away from crowded restaurants.
At least in this country, little of this has happened yet. Planes are still full, although you see a few more people wearing masks than before. Businesses are operating and consumers are active. That doesn’t sound like pending recession. The worst may already be over in China. The spread to Italy, South Korea and Iran is obviously concerning, and who knows where the virus will appear just a few days from now. It is highly contagious and hard to spot in its early stages. But it will run its course, and over the next several months it will become a much smaller economic concern.
Stocks are priced based on long-term cash flows. A one or two quarter disruption does matter, and that is why stocks have declined as far as they have. If the disruption lasts for several more quarters, further declines are possible, if not likely. But this disease alone won’t dictate the long-term value of an enterprise.
There are ancillary factors to consider. Interest rates are falling rapidly as investors flee risk assets and buy anything with a yield they deem safe. The 10-year Treasury bond now yields about 1.3%, hardly enough to keep even with inflation. But it is better than zero. Central banks say they stand ready to inject more money into the system if liquidity dries up due to the spreading virus. The S&P 500 dividend yield is now almost half a percentage point higher than the 10-year Treasury, a situation that isn’t likely to endure for long. Stocks compete with bonds for investor dollars. It is illogical for stocks to move sharply lower and bonds to move sharply higher for long, unless there is a true economic disaster. I suppose that could happen, but it is extremely unlikely. But that is what happens when emotion takes over from rational thinking.
I don’t know how much lower stocks are headed and neither does anyone else. If recent patterns reoccur, the current decline is likely to be both sharp and fairly quick. Markets have gotten rather efficient at finding a new fair value in response to either outside influences or to periods of over or under valuation. A long response may be 2-3 months, whereas a short response could be just a few weeks. This time a lot will depend on the spread of the virus. The two obvious alternatives are to sell and hope you can catch the bottom, buy back in then, and save some serious money and pain. The other is to ride it out, recognizing that when the virus finally fizzles out, life will return to normal and valuations will rebound. The former sounds good but (1) the bottom could be the moment you sell, and (2) if you don’t buy back near the bottom, you might end up buying back at higher prices.
I have no idea whether we are in for a 10% correction or a 20% correction. I do think it is in that range. If there is a world pandemic that lasts for a few months, the latter is more likely. But while the media will scream out the case numbers and fatalities, once it passes, and it will, normality will be restored. Perhaps the rush to find a treatment or vaccine will stem the tide earlier than anticipated. Remember, stocks discount what we know and expect, not what we don’t know. Right now, we expect the virus to spread rapidly, at least that is what we are being told. That is a bit scarier than a week ago. Hence an almost 2000-point decline in the Dow in 2 days. From here, the messaging could get better or worse. No one knows. That will dictate the short-term course of stock prices.
Remember that stocks weren’t all that cheap a week ago. Now they are back to late October levels. That still isn’t cheap, although many issues are no longer expensive. As the market grapples with trying to find a bottom, the moves in both directions could get even sharper. The VIX volatility index, now in the mid-20s, could spike to over 30. Yesterday the market opened higher and finished down 3%. It wouldn’t surprise me to see the market gap down 3% one day and finish higher. That’s how bottoms are formed.
My best guidance is to take a little money off the table if you are nervous, particularly in stocks that are still richly priced. But don’t panic. If you have cash ready to invest, don’t stand in the kitchen and try to catch a falling knife. A real bottom will be the starting point of an enduring rally. If you miss the first day or two you will still land some bargains. Make a shopping list. Be ruthless with your buy targets. Remember, you are trying to catch a true bargain. If the stock you love falls to your target, buy a little. Not a whole position, but a little. If it falls further, buy a little more. That’s how you build positions at bargain prices.
I did say several times not to panic. But you must be careful. There will be some weaker companies that are cash tight that are going to be cut off from capital when they most need it. Some smaller oil drillers and a few weaker retailers come to mind. You don’t want to own these, period.
So, take a deep breath and hope for the best. Next Tuesday is Super Tuesday. By next week, we should have a lot more clarity on the virus and on our election scene. Hopefully, clarity will lead to better times. Unlike last week’s debate, last night’s rather unruly affair probably didn’t sway many voters. Don’t panic and don’t dive into an empty pool. Relax. This isn’t a Hollywood movie. The world will endure this event as it has endured all others.
Today, singer Michael Bolton is 67.
James M. Meyer, CFA 610-260-2220