What a difference a day makes. After rising a record 1200+ points on Monday in one of the biggest relief rallies in stock market history, equities reversed course and fell over 2% once again yesterday. This was despite a historic 50-basis point rate cut intra-FOMC meeting by the Federal Reserve. While one can argue that the cut had been anticipated, the reaction once the cut was made had to be classified as disappointing.
Before getting into too much detail about why stocks have been acting the way they have, I want to make note of the spike in volatility, the extreme gyrations in equity prices, and the hysteria present at the moment. This is all part of a bottoming process. That doesn’t mean we have seen the lows. But we might have. What we do know is that we now have two markers rather far apart, the highs of just a couple of weeks ago at the high end, and the lows set mid-Friday of last week before the 600-point rally into the close. Individually, almost every stock set its own set of markers as well. If we have seen the bottom, those lows have to hold.
The coronavirus isn’t about to disappear. What is happening now is that the real world is catching up with expectations and it is beginning to cause some real time pain. A lot of this, obviously, has been discounted by the sharp drop in market prices over the past couple of weeks. Whether expectations got it right or not is the $64,000 question. Right now, it is a fair guess that none of us know anyone firsthand who has the virus. That will all change over the next several weeks. It is almost certain that tens of thousands of Americans, maybe a lot more, will contract the virus. With tens of thousands of test kits soon in doctors’ hands, the number of reported cases will spike. We have no idea at the moment how present the virus is today in our country because so few have been tested. Many will get sick and, unfortunately, some will die, consistent with all viral epidemics including the flu. But what remains a big unknown is the economic impact. We won’t truly have a grip on that until first quarter earnings are reported and corporate managements give specific assessments of their outlooks of the remainder of the year.
Indeed, one likely outcome would be for markets to rally sometime soon, recover about 50% of the losses of the past few weeks, and then retest lows as the economic reality of the coronavirus really hits home when companies start to report earnings results.
With that said, the impact is a temporary one. It may be larger than expected (or may not be), and expectations will have to be reset for both the remainder of this year and next year. As I indicated on Monday, this is still not a cheap stock market in terms of earnings multiples, although the Fed Funds rate cut and the sharp drop in commodity prices suggest inflation readings in the months immediately ahead of us will be much less than the recent readings of 2%+. But they too will only be temporary. The rate cuts will have some real-world benefit. Over the next month, for instance, we are likely to see a record number of applications to refinance mortgage loans.
Let us not lose sight of the other major news story, the fight for the Democratic nomination for President of the United States. Last night has to be labeled as a resounding victory for Joe Biden. Just a week ago, his candidacy seemed in jeopardy. But a big win in South Carolina and new support from former centrist candidates Pete Buttigieg and Amy Klobuchar helped to lead him to a very strong showing in last night’s Super Tuesday elections. His victories in Texas and Massachusetts were especially notable. Mr. Biden now has the lead in pledged delegates. While the race is still too early to call, a week or so ago the question was would Bernie Sanders have an unstoppable lead by this morning. The answer to that is clearly no. Financial markets fear Bernie Sanders. Whether they should or not is a political question I won’t even attempt to answer. But a Biden win, combined with a market searching for a bottom, means stocks are likely to be up by a healthy amount this morning.
Don’t forget my two-day rule. There isn’t an all-clear signal until we see at least two good up sessions in a row. Many of the biggest one-day rallies in history have happened during market corrections. The good news is that they often happen near the end of the correction cycle. As I noted earlier, we may have seen the lows last Friday morning in the overall averages. But we may not have seen the lows for every stock.
Every company will be affected by the virus in different ways. Companies that sell surgical masks or disinfectant wipes will actually benefit, while no one will suffer more than the cruise ship companies. Companies doing business in China will suffer more as well. Energy will be a notable weak spot. Commodity prices probably won’t recover to recent highs very quickly given the buildup of inventories caused by weakened demand. New drilling activity will weaken noticeably. Thus, as an investor, you need to look at every company you own and ask if the hurt is just a temporary speed bump or one that will last for many months if not longer. Energy experts have been overestimating demand for the past several years. While alternatives are still a very small proportion of overall energy supply, they are growing rapidly. Just a fraction of a percentage point decline in the worldwide demand for oil, for instance, can amount to several hundred thousands of barrels, enough to tip prices in a meaningful way. There can always be a politically or war- inspired shortage of oil in the future, but it seems clear that the only way to balance supply and demand going forward is for major producers to hold back some amount of production. That isn’t a rosy picture.
The bottom line is that we are coming closer to matching coronavirus fears with reality. However, it is a process that will take another month or two to resolve. The 10% or so decline in equity prices to date has (1) done a reasonable job of resetting economic realities, while (2) removing some of the froth that existed in equity prices after a 30-40% run over the previous 12 months. That will be fine-tuned, company by company, as Q1 earnings are reported. Thus, even if there is a solid rally near term, it is reasonable to expect some retesting of recent lows as earnings are reported. Second, the Democratic run for the Presidency is now a two-man race, one that is still undecided. I would expect Michael Bloomberg and Elizabeth Warren to drop out soon. Mr. Bloomberg performed miserably last night, but might have been an important voice to wake up the moderate wing of the Democratic Party. As for Ms. Warren, she couldn’t even win her home state of Massachusetts. Unlike Mr. Bloomberg, she doesn’t have unlimited funding. I would expect both to disappear quickly, leaving Democrats a stark choice that will play out in the weeks and months ahead.
Finally, there is the question of valuation. The drop in yields is real. Stocks and bonds compete for investor dollars every day. The 10-year Treasury yield overnight was less than 1%. The move lower is partly due to investor fear. They fly to safety in times of stress. But it is also a sign of worldwide economic weakness. This has been a fragile economy for some time, propped up by very accommodative monetary policy. While yesterday’s rate cut will add to economic growth with housing at the epicenter, the Fed can’t force people to take off their masks and run out and spend money. Think of the season-end sales at retail stores. At some point, what’s left is so awful and picked over than no one will buy it. Or, how many pairs of shoes do you need in your closet? The good news of recent months is that consumers are healthy and they are spending. Virus aside, that continues to be true. But, as I have said many times before, we live in a world with way too much capacity. Incentivizing businesses around the world to build more factories, more buildings, and more stores adds to the pain. It doesn’t solve the problem. Capital spending is weak because businesses understand there isn’t a need for more capacity. Where they are spending is to apply new technologies to a changing world and to become more efficient.
Once again, the oil industry is the perfect example. What we need isn’t more supply. Investors have been shouting to oil companies for years that they want positive cash flow, not more reserves. The companies are finally listening, but it may be too late. The outlook for strength in oil and gas prices is bleak. All very low rates will do is keep the marginal producer in business longer, exactly what you don’t want to see.
Putting all of this together, the worst may be behind us, but the reality is that even if consumer spending stays robust, as it should, excluding any near-term virus impact, investment spending will stay weak. The 2-10-year yield curve has actually steepened a bit during the recent hysteria, suggesting that there is continuing strength. But without robust investment spending, 2% growth with 2% inflation is probably all one can expect. That isn’t so bad. It hasn’t been so bad for the past 10 years. But that is already priced into markets, suggesting that between now and the election we should expect choppy markets, not a robust recovery. The real key for equities is where will the 10-year yield be by year end. If it is near current levels or lower, equities can have better than expected performance. But interest rates so low that capital is free in real terms will only perpetuate and extend the overcapacity issues that exist today. The world depends on economic balance. Forcing the world to do what China has done over the past decade, building zombie plants, roads and airports, isn’t a long-term solution.
Today, actress Catherine O’Hara is 66.
James M. Meyer, CFA 610-260-2220