What a week! Stocks fell by 10-15% with all S&P 500 sectors falling at least 10%. Coronavirus fears dominated the news as cases spread around the world. Over the weekend, they spread further, and we are still in the early innings of a worldwide assault that won’t peak for several weeks, if not months.
But stock markets react to economics, not diseases, and not wars. What concerns markets is the economic impact of the virus, not the virus itself. Governments around the world are reacting quickly and forcefully. Airline routes are being shut down. Large gatherings, like business conferences, are being canceled or postponed. Even the Louvre was closed over the weekend. Nike is closing its headquarters for a deep cleaning. While new cases continue to show up in China, the epicenter of the outbreak, the number of new cases there are falling. By now, either you got the virus, or it passed you by in many cases. The trend in China is likely to be replicated around the world. It will take 2-3 months to peak in each geography but, hopefully, by late spring or early summer, it will have largely passed.
The damage, economically, will be real. Chinese economic activity in February declined dramatically, a reaction that is likely to be replicated to some degree all over the world. In some places schools will be closed, although children seem less impacted than adults by the coronavirus. Public venues such as museums may also be closed. Workers will stay home, and output will decline for the next several months.
This was all expected last week, although now the expectations are becoming real. A 13% decline in equity values clearly indicates a reaction to the new reality. The question is whether the reaction was too much, too little, or about right. Given where inflation is, around 2%, an 18x forward earnings multiple can be justified. At the same time, the virus will clearly lower both 2020 and 2021 earnings estimates. The biggest impact will be on the first two quarters of this year. You may ask “Why take down 2021 estimates as well?”, and I would answer (1) we will be starting from a lower base and (2) the impact on some industries (e.g. cruise ships) will carry over into next year. Thus, consensus earnings estimates of $175 for the S&P 500 this year may now be closer to $160, maybe even a bit lower than that. The $175 number may be a good target for next year.
Using an 18x multiple, $160 times 18 is 2880. The S&P closed Friday at 2964. Given the extreme volatility of the past week, I would suggest the reaction of the market has placed it fairly close to fair value. In other words, the revision last week wasn’t extreme, it was within bounds of reason.
Let me go further. Markets were begging for a correction before the coronavirus even hit. They were waiting for an excuse. Markets don’t normally go up in a straight line, but since the Christmas 2018 bottom stocks have risen about 40% without a 5% correction. Thus, the decline can be attributed both to the coronavirus and to a normal corrective process in a market that had gotten at least a bit ahead of itself.
Then there is Bernie. I don’t have any better idea than anyone else whether Bernie Sanders will be the Democratic nominee, and if he is, whether he can be elected President. But I do know that Wall Street investors do not like the prospects of a Sanders Presidency from an economic perspective. Last week, after his resounding win in the Nevada caucuses, the odds of his at least getting the nomination, increased. The larger-than-average decline last week in health insurance related stocks, for instance, clearly had a Sanders connection. Therefore, add a Bernie factor to the explanations for last week’s decline.
What about this week? The South Carolina victory for Joe Biden may help today, but tomorrow is Super Tuesday and we will get a much better picture come Wednesday morning as to who the ultimate Democratic nominee might be. At a minimum, the field will be narrowed. As for the virus, it is hitting us in real time, but last week’s decline appears to have already discounted the spread across both the U.S. and the world. There is little doubt that all 50 states will experience the virus to some degree before it runs its course, and thousands of Americans may die from it, not totally dissimilar to what happens in a bad flu season. It is also clear that this time around the reaction will be much more fearful and much more extreme than what happens during a typical flu season. Hopefully, as we all wash our hands more, shake hands less, and take sensible steps to reduce risks, the virus can be less than anticipated and both the economy and stock market can rebound before too long. But unless Covid-19 is much worse than feared, the lion’s share of the damage is probably priced into the market.
With that said, the impact to earnings is real, and the correction in stock prices last week is unlikely to be recovered fully for some time. As summer and fall approach, election politics will come into play more, and I won’t attempt to forecast that outcome on markets until we know the nominees.
30%+ up years in the stock market are almost always followed by up years. There was a reason for last year’s rise. While the virus represents a significant pothole along the way, it won’t derail a basically solid economy and it certainly isn’t about to increase the pace of inflation. Indeed, reduced demand caused by the virus will increase stockpiles of oversupplied goods. I suspect that when 2020 is over, stocks will be modestly higher year-over-year. Right now, the S&P 500 is very close to where it was in September 2018 before the 20% decline of the fourth quarter. Yet earnings today are higher and interest rates are much lower. Stocks yield over 1.8%, while 10-year Treasuries are trading at yields closer to 1.2%. Stocks are either cheap relative to bonds, or bonds are very expensive. I would argue that the best trade for the balance of 2020 may be to sell 10-year Treasuries today and buy them back after the virus abates. There is a long history that suggests bond rates fall as fear increases, but normalize as fear dissipates.
The next several days in the market are likely to remain volatile. The overnight futures session ranged from losses approaching 1.5% to moderate gains. Friday’s market swung by almost 2000 Dow points. It may be nice to know that central banks are ready to cut interest rates once more, but that is offset by ongoing unknowns associated with the virus. But unless an epidemic becomes a pandemic beyond what we envision today, one that lasts many months or more, most of the damage to stock prices was probably done last week. That doesn’t mean, in the extreme, that prices can’t fall another 5-10% but I don’t think further declines will be sustained if the virus’ impact stays within a reasonable range of expectations.
Today, Daniel Craig is 52. Jon Bon Jovi turns 58.
James M. Meyer, CFA 610-260-2220