Good Afternoon Clients, Colleagues and Friends,
This morning the World Health Organization officially declared COVID-19 a global pandemic, as the coronavirus continues to spread throughout the world and the death toll mounts.
Our last Client Update issued about a week ago, focused on the fear associated with the spread of the virus, the impact that was having on the capital markets, and potential implications for a recession.
In this update, and with a week of additional return data under our belt, we take a deeper dive into the potential impact of the coronavirus and address the questions: how bad could this get, and at what point is there a buying opportunity in the equity markets?
As of this writing, Weds 3/11/20, equities have resumed their downward spiral trading off appx. -5%, after staging a short-lived recovery yesterday ending up ~5%. This volatility is in direct response to the coronavirus and a simultaneous steep decline in the price of oil resulting from the pricing war between OPEC and Russia.
Investors, including our clients, are wrestling with some combination of the following questions:
- “Do I buy these dips and try to profit from the current volatility?”
- “Do I sell my equities in advance of a recession led bear market?”
- “Do I wait until a recession and try to buy into equities at the technical bottom?”
- “Do I just hang onto my existing equity positions and ride this out?”
#1, buy the dips and try to time the market, is a fool’s errand, and has likely already resulted in some investors getting whipsawed as they missed unexpected up days while out of the market. Don’t think that hurts you? Take a look at the chart below and you will never day trade or market time again.
#2, sell my equities in advance of a coming recessionary sell off, is a bad idea for the same reasons as #1: no one can predict what the market will do, and missing up days absolutely kills your long term returns. Take another look at the chart above, and then let’s move on to #3 and #4.
There may be a legitimate opportunity to buy into equities in the coming months, and #3, wait until a recession and buy into equities at the technical bottom. The challenge with this strategy is that you only know where the technical bottom was looking in your rear view mirror, and by that time, the opportunity to buy in has passed.
The best any of us can do, is pay attention to the best, most relevant, economic and market data we have available, and plot a course from there. To that end, here is what we are looking at when we think about a potential entry point into equities:
- Although we have seen the equity market yanked up and down in intraday trading, there is a dearth of actual economic data detailing impact at present. It simply doesn’t exist yet, and therefore cannot be analyzed. Realistically, it won’t exist until Q1 ends and companies begin to report earnings (which are all expected to be negative), and the macroeconomic consequences of COVID-19 can be measured and reported on.
- Historically, equity bear markets tend to trough after the media begins reporting on actual negative economic data in earnest, but before a recession is actually declared (after two consecutive quarters of negative GDP growth). Based on how dismal Q1-20 has been, this would be sometime in the April or May timeframe. Take a look at this piece published by our friends at Goldman Sachs Research. It does an excellent job of breaking down some of the critical data points associated with bear markets, in a useful if/then playbook format.
- At present, the market has given up “almost” all of its gains since the beginning of 2018. However, that is still only an 18% correction off its high, and that is largely based on investors’ trying to benchmark economic impact of coronavirus, and now a sharp decline in the price of oil.
- Take a look at this table, which illustrates S&P 500 earnings by year. Currently, S&P 500 earnings are at $133.53. In the event of a recession and accompanying bear market, we could see earnings drop into the $106-$118 range, or below, based upon earnings multiples dropping from their present 20x to the historical long term average of 15-16x. Keep in mind, this is just a reversion to the long term mean, and if that occurs, we would see another 30% drop in the price of equities, at least.
- In the meantime, treasury interest rates have dropped over 75% in the last two weeks, while the stock market has only declined about 18%. Treasury rates are signalling an almost certain recession and consequently a much steeper drop in the equity markets than we are seeing at present.
10 Year Treasury Constant Maturity Rate – Last 5 Years
Source: St. Louis Fed
- Historically, bear markets associated with recessions have produced stock market drops in the 30-50% range. At 18%, we have a long way to potentially fall from here before we see a technical bottom, if we do enter a recession. If this comes to pass, and if indeed the stock market troughs shortly after the first quarter of negative GDP data, the most opportune time to buy into the market will be in the April/May timeframe.
- We are therefore not yet tactically entering the equity markets, as we feel it is likely there could be significant downside risk that is yet to be realized. That said, volatility can cut both ways, so if you are already in the equity market: stay calm and carry on. This is not looking like a repeat of the GFC where financial markets and liquidity seized up entirely and global banking came to its knees. When we get through this, the market could recover swiftly and on an aggressive trajectory.
- That said, a recession and associated stock market drop is not yet a foregone conclusion. The Fed’s response to Q1 economic data will be critical. We have already seen that rate cuts (monetary policy) have had no effect on the market correction. We believe the Fed will have to come to the table with more than rate cuts. The market is looking for targeted fiscal policy (ala TARP in 2008, and potentially tax cuts and incentives for hard hit industries and sectors, like travel and leisure), in order to have a positive impact on the stock market. The market needs to know this slowdown in economic activity is not going to lead to a large increase in unemployment and corporate debt defaults.
- Further, it appears that China’s eventual aggressive response to coronavirus containment has resulted in steady declines in the contraction rate, and we could see supply chains begin to re-start in the next month. If news of the virus’s spread gets materially better, the markets and economy could stage a rapid comeback.
Practically speaking, we need to be mindful to avoid becoming overly negative on the markets considering:
- This economy started the year as a fairly healthy patient
- This is an election year that will attract all sorts of government programs to avoid recession.
- The virus appears to be seeing signs of containment in China
- The virus may be susceptible to heat and could begin to see its activity rate decline with warmer weather.
- There will likely be positive news regarding a treatment cocktail as a precursor to potential vaccine at some point this year.
So where does this leave us and what are we doing about it? While we are not comfortable calling a top or bottom to the rates or stock market, we are looking for opportunities to capitalize on this near record volatility, when the time is right. In other words: #3, wait until a recession and try to buy into equities at the technical bottom.
We are currently working with our underwriting partners and obtaining pricing on structured notes which provide hedged exposure to broad markets like the S&P, but with unlimited upside potential. We have structured several such bespoke notes in the past, and they are particularly attractive in times of high volatility, because they are more favorably priced.
If and when we believe the market is presenting an attractive entry point based on current market conditions and economic data, we will be working with our clients to deploy capital earmarked for growth over the next 5-7 years.
As always, we are here to answer any questions you may have about any of the above, or its potential impact on your portfolio or financial plan. So, please don’t hesitate to reach out. In the meantime, keep calm, stay the course, and remain invested: #4, hang onto my existing equity positions and ride this out.
Three Bell Capital