If you are lucky enough to have a 401(k), first of all, congratulations. You are preparing for retirement when you’re young, likely 30-plus years before you say goodbye to your working days. That’s the best possible way to prepare for your golden years, regardless of how fast your portfolio grows. For folks in that group, the value of time (read: compound interest) is worth more than a single annual return in the stock market.
However, if you do have a 401(k), or any investment portfolio with a heavy concentration in equities for that matter, unfortunately, it has probably gotten crushed lately. The S&P 500 is down roughly 10% from recent highs, which in finance speak, is a stock market “correction.”
The bigger question on my mind is: Is this purely a short-term correction, just an overreaction due to coronavirus fears, which will quickly dissipate once the outbreak is contained? Or is coronavirus the match that will ultimately light the fire of the next global recession, depressing stocks further and increasing unemployment?
You remember the doomsday verbiage from 2008, don’t you?
Before we continue, I’d like to make some important distinctions regarding the coronavirus to ensure we’re all on the same page. I welcome any comments if you disagree.
Death Rates are not so important (to the market). No one cares about your seasonal flu statistics and death rates here.
Depending on which index we observe (e.g. Dow Jones Industrials Average versus S&P 500), the week of February 24, had some of the most volatile days in the stock market since 2008. The Dow dropped 3,600 points in that span. Personally, I prefer not to use points as a benchmark. If you don’t have the current overall index level memorized, point drops are an absolute statistic, which makes the relative value of that drop harder to grasp in comparison with total value of the index. One widget out of 2 is a much higher percentage than one widget out of 100. Those 3,600 points equaled a 12.6 percent decline; one of the fastest, largest moves in the DJIA in history. The 10-year treasury yield also blew past it’s all-time low of 1.35 percent, piercing below 1.00 percent and currently sitting at 0.97 percent (as of March 4). These two combined market moves (major stock market declines and concurrent decreases in rates) are called a “flight to quality.” In other words, investors sell stocks, a.k.a. risk assets, and immediately buy US government treasury bonds as a short-term risk haven, in order to protect principal and try to wait until the stock sell-off ends.
Quick note: if you were considering buying a house, taking a second home mortgage, or doing nearly anything involving borrowing money, rates are currently at their lowest point in US history. So feel free to ask your banker for a rate refresh, and don’t be surprised if the rate is significantly lower from last month, or last week for that matter. You can thank coronavirus for that.
Now back to why death rates are not so important. I promise I’m not just some savage on the street. We showed above how violently the market reacted to the threat of Coronavirus last week. Much of finance and economic prediction is based on precedent, so let’s look at a past viral outbreak for reference, the Ebola virus in 2014, and how the market responded.
According to the CDC, there were 28,652 total cases of Ebola around the world and 11,325 deaths. That’s an objectively high death rate of 39.53 percent. The outbreak occurred in early 2014, but the stock market only went down around 8 percent, at worst, during that year. Over the entire year of 2014, the market actually went up 13.21 percent, on an annual basis. If Ebola was significantly more deadly than coronavirus, why didn’t the stock market sell off as violently back then? We have the benefit of retrospect here. It’s unknown how the stock market will perform for the rest of the year, but the analysis might still be relevant.
The first and primary difference is that Ebola never materialized into a true global outbreak. Of those 28,652 total Ebola cases, only 35 cases were outside of Guinea, Liberia, and Sierra Leone. The vast majority of the disease and its effects were localized to West Africa. To be fair, international travel was also limited slightly as many airline and cruise stocks were down about 20 percent during that time. However, manufacturing supply chains generally remained intact and the threat of actual rampant communicability was apparently low, despite the narrative at the time.
The second difference is the coronavirus outbreak originated in China, the manufacturing mecca of our globalized world. As the Chinese government implemented quarantine measures, many manufacturing plants, which made products for many companies across the US and the world, were restricted from operation. This is the root of the “supply-side shock.” If companies cannot complete their products because certain components are stuck in China, they cannot sell them to customers, which lowers profits below previous predictions. Comparing the original outbreak location of Ebola to Coronavirus, West Africa just did not have the same global reach as China in terms of supply-chain disruption.
The threat of communicability is the other wildcard. As of March 3, there have been 90,870 confirmed coronavirus cases; 10,566 have been outside of China, with 3,112 global deaths (around a 3.42 percent global death rate). More importantly though, Coronavirus has spread globally from its initial outbreak in China, despite countermeasures. Companies and countries have responded in turn by shutting down schools (Japan), and limiting global business travel for employees (Ford, Google, Amazon, JP Morgan, and probably your employer by the time you’re reading this). Even the Olympic Games, scheduled to be held in Tokyo this summer, are considering a postponement. These countermeasures are being referred to by a new term, or at least to a new term to me, called “social distancing.” Social distancing describes certain actions taken by public health officials to stop or slow down the spread of a highly contagious disease. This is the flip side of coronavirus risk: the demand-side shock, which I think is currently undervalued in the market. Consumers are being encouraged to stay away from large groups, limit unnecessary travel, and basically just stay in their homes if possible. With less travel and mobility, there is decreased demand for almost all products, which further reduces future growth and earnings expectations.
Both macroeconomic functions have significant downside risks because of coronavirus: supply-side, due to the geographic epicenter of the virus (China), and demand-side, due to global communicability countermeasures, which limit expected consumer behavior. The actual death rate is not as important here, it is the potential economic reaction to the outbreak that is the concern.
Lastly, there’s the Federal Reserve. Chairman Jerome Powell delivered an “emergency” 50 basis points (bps) cut in short term rates on March 3 in an attempt to stabilize investor behavior. This was the first unscheduled, emergency rate cut since 2008 and it also marked the biggest one-time cut since then (other cuts/hikes have been in 25-bp increments). Both the magnitude of the change and immediacy of the decision, exemplifies how significant the coronavirus risk has become and the need to address the fearsome sentiment in the stock market. Although a rate cut won’t cure infections or fix broken supply chains, Powell noted, “It will help boost household and business confidence.” This is more of a hope than a causation function, but it should be noted that historical fed cuts have successfully helped stabilize the stock market and led to growth in equity prices. This has also been coined the “Fed Put.” In other words, when the fed cuts rates, it indirectly creates a floor for stock prices, incentivizing investors to buy if they believe down-side risk is low to zero.
Will the “Fed Put” work in the coronavirus context, though? Cutting rates doesn’t appear to remedy anything fundamentally related to the true risk of the coronavirus. If the worst outcome materializes (a true global pandemic), what does it matter how high short term rates are? The move was really only made to affect investor sentiment. Globally, other central banks have acted similarly. The Reserve Bank of Australia cut short term rates on Tuesday, and the Bank of Canada also cut rates on Thursday. At first glance, it appeared the market welcomed the cuts. The S&P was up around 3.00 percent on Wednesday, March 4, but then went down more than 3.00 percent on Thursday.
My biggest concern is if the coronavirus has intangible long-term effects. What I’m talking about is heightened rhetoric of deglobalization. Jingoistic politicians may see coronavirus as a propitious moment to argue for more restricted mobility between countries, now due to health concerns, and companies may look to restructure their global supply chains to avoid a similar stoppage in production in the future. If you have followed any news since 2015 or so, populism and nationalism have obviously become powerful trends around the world (between Donald Trump and Brexit alone). Deglobalization is bad for the economy, specifically growth rates, plain and simple. Depending on who you ask, it might be better on the aggregate for one society when considering health, social, and security factors, but deglobalization is bad for world economics and future growth prospects, no matter what. It limits the available market (customers) to companies and it hinders ability to produce efficiently and cheaply due to supply-chain restriction.
Lastly, some of us might forget the ominous yield curve inversion signal by the US bond market in 2019. A yield curve inversion almost always precedes an economic recession within 18 months. Investors, at that time, seemingly forgot about the risk given the apparent strength of the US consumer due to increases in wage growth, etc. However, I am afraid the coronavirus may reignite that recession-risk conflagration. Leveraging the coronavirus to justify deglobalization would also make a real change in long-term growth expectations and, unfortunately, further increase downside risk.
In the short term, I’m not sure if this is the type of market you want to “buy the dip” on. Volatility is just too high, at least for me, to ascertain an equilibrium level or “fair value” price for stocks. It’s a pivotal point in the market, make no mistake. If the first scenario becomes reality, that the coronavirus risk is purely transient in nature with no long-term consequences, then it might be a perfect “buy the dip” opportunity. Human nature reacts excessively in fear, and if positive news emerges, i.e. infection rates go down, a treatment is developed, or countries end travel limitations, one could expect the stock market to recoup its losses in the short term (less than one year). If the worst-case scenario materializes, the coronavirus truly advances into a global pandemic and causes a recession, then another 10% drop in the stock market is almost guaranteed, and even worse, it could curtail long-term economic growth rates (this, plainly speaking, would be really bad).
If you are thinking of buying options either way to exploit volatility, please be aware that the market incorporates volatility into option pricing accordingly, so any option (call or put), will be more expensive than normal. Think of options as insurance. Say you wanted to buy flood insurance, and there have been three floods in the past month. In addition, all the weathermen continue to talk about the high risk of a massive hurricane, with even more flooding in the near future. You can bet your flood insurance quote will be higher than normal. The same concept remains with option pricing.
Here, at Stern, it would definitely be an opportune time to take the famous Volatility class with Professor Engle and brainstorm some trading ideas. Unfortunately for me, I’m taking Operations Management and Statistics this semester.
One of the hardest things to do in life is to admit you don’t know something. In trading, if you don’t know what you’re doing, or better yet, why you’re doing it, you are probably going to lose money. It is probably better to admit you don’t know what will happen (because really, no one does at this point) and let things shake out before booking any trades and getting caught speculating, a.k.a. gambling.
Disclosure: This article is for informational purposes only. The Stern Opportunity is not rendering or offering to render personalized investment advice or financial planning advice. Investing involves the risk of loss and investors should be prepared to bear potential losses. No portion of this article is to be construed as a solicitation to buy or sell a security or the provision of personalized investment, tax or legal advice. Certain information contained in this presentation is derived from sources that the author believes to be reliable. However, The Stern Opportunity does not guarantee the accuracy or timeliness of such information and assumes no liability for any resulting damages.
Photo credit: https://www.thejakartapost.com/news/2020/02/28/coronavirus-crash-wipes-5-trillion-off-world-stocks.html