The major US stock markets—S&P 500, Dow Jones, and tech-heavy NASDAQ—took a beating over the past week. Each is down 12% or more off their historic highs last week, putting them into what’s called “correction” territory.
The overwhelming reason for the sell-off is the increasing fear that the coronavirus may be spreading worse than initially expected, leading to greater economic fallout.*
Human nature is for this type of turbulence to rattle investors and leave them wondering how much further stocks will tumble, how long recovery will take and what actions investors should take in the meantime. In response, the CornerCap investment team offers the following perspective.
Analysis of Current Market Reaction
First, our perspective on and analysis of the coronavirus issued earlier in February still applies:
- We are likely in a six to 12-month transition period until a vaccine is found and produced in scale. The pace and smoothness of that transition will be determined mainly by how well global health organizations and national/local governments execute.
- Efforts to contain the virus will likely have a major, negative impact on economic growth for at least the near term, largely due to disruption to China’s economy and its spillover to global supply chains, logistics, and networks. Warmer summer months could help slow the spread of the virus, buying time for solutions.
- Meantime, we expect market volatility to increase as investor fears ebb and flow on the headlines. Investors, companies, and communities are primarily at the mercy of government and health officials during the transition to normality.
This week, investors began doubting that governments have effectively contained the virus. Italy reported a broader outbreak, Japan closed all schools for a month, and the CDC said they expect the virus to spread to the US. We are not surprised by a near-term sell-off, absent any additional encouraging news on containment.
Second, our own opinion is that the spread of the virus is unlikely to lead to recession. Our reasoning:
- So far, this is a government-induced slow-down, which has forced suppliers to curtail activity until further notice. However, underlying consumer demand is relatively intact. Will demand return once governments remove restrictions and suppliers operate freely? We certainly expect some weakness (fear could continue to impede tourism and recreation, for example), but we don’t yet see a permanent hit to broad underlying spending.
- For illustration, we recall the dynamics after the terrorist attacks of 9/11/01: coordinated government action closed airports and borders, which impeded economic growth during a period of transition; stocks initially traded off, but the consumer returned relatively quickly as restrictions eased. The coronavirus is arguably more serious (more lives and communities affected), but it could follow the same pattern.
- The market is forecasting a high probability of at least three rate cuts by Central Banks later this year. In fairness, rate cuts are not likely to ease government restrictions or rejuvenate supply chains, but they could encourage further lending to support growth, as long as the yield curve is upward sloping.
- The level of market pessimism may be overstated. There’s evidence that trading strategies being implemented by large institutions is amplifying negative near-term effect on markets. An example of this is program trading, whereby algorithms determine buy or sell decisions. When lower levels are breached as we have seen this week, program selling intensifies, causing further downside momentum…and so on. The greater the down-side volatility, the greater the selling activity. In theory, the opposite is true as well—to the upside.
As a final note, bond markets remaining open and functioning is critical to overall market recovery. Many companies have binged on debt and carry a heavy load; if they are cut off from credit markets, they would likely encounter a credit crunch. We think this is a separate issue from the virus, but it could come into play if the consumer retreats and the yield curve inverts.
Third, meaningful changes in markets create opportunities for those following a discipline. Markets obviously are not static, and extremes occur frequently enough. Last year, we had already begun seeing imbalances in SIZE (small stocks had become more attractive than large), STYLE (Value stocks had become more attractive than Momentum/Growth) and REGION (emerging and international stocks more attractive than US).
It is too early to tell how the sell-off is adjusting these specific opportunities, but investors are clearly rushing to defense in the form of investment grade corporate bonds and U.S. Treasuries. This has driven down the yield on 10-year Treasury to record lows and increased stock dividend yields (as stock prices fall). Comparing stock dividends to bond yields offers a useful comparison about relative attractiveness between stocks and bonds. At this point, consider that 64% of stocks in the S&P 500 currently have dividend yields that are higher than those of 10-year Treasury bonds. The average over the past ~30 years is about 18%, indicating a dramatic differential.
We aren’t calling a bottom to equities by any stretch, but we are illustrating that market gyrations create new risks and opportunities for the alert investor following a disciplined approach.
Key Take-Aways for Investors
We expect market volatility to continue as investors navigate this period of transition, from outbreak and spreading of the virus to eventual containment. The process could take six to 12 months. Global growth is likely to slow materially—perhaps to zero in 1Q—but we would need to see a shock to global demand, particularly from the US consumer, to drive sustained negative growth.
Regarding investment strategy, our Fundametrics research system is systematic and unemotional in its application. With a focus on relative rankings of stock specific bottom-up fundamentals, our models will identify opportunities. In the short term, markets move quickly and yet behave just as emotionally as people do; reacting to fearful headlines usually takes investors off plan, to the detriment of long-term investment success. As a reminder, we treat the virus the same as we treat tensions in the Middle East, challenges in trade negotiations with China, or predictions about Presidential elections: they each embody the uncertainty that’s inevitable in investing. Macro events can be influential but cannot be predicted as to timing and duration in a quantifiable way and therefore are not inputs to our models.
We welcome discussions for clarification or to challenge our thinking. Please contact Derek Tubbs to set up a call with our investment team.
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*We’ve seen some comments that the sell-off may also reflect concern over higher prospects of a Bernie Sanders Presidency, but we doubt that’s the case since health care stocks—which could be threatened by his preference for nationalized health care—are actually holding up better than the overall market.