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Coronavirus: A Framework for Market Shocks

by Catherine Trinder Miller, March 12, 2020


Financial markets teem with Animal Spirits, a term coined by economist John Maynard Keynes to describe irrational behavior in times of economic stress and uncertainty. It was only two and a half weeks ago that the US equity market reached all-time highs.2 The speed of the latest price correction has been staggering.

It is during these times that pre-defined plans and frameworks are most valuable. Using history of prior market shocks as a guide, financial markets typically move through four phases.1 Each phase is not distinct, but rather feeds upon another in a cascade of events.

  • Phase I: Reactionary – This wake-up phase began swiftly two and a half weeks ago as the COVID-19 virus spread accelerated outside of China;

  • Phase II: Liquidity – As volatility increased, market makers and systematic strategies reduced risk exacerbating price moves. Saudi Arabia’s surprise initiation of an oil price war with Russia was further catalyst for risk reduction. Thankfully, U.S. banks are in strong capital positions due to tighter regulations and capital rules coming out of 2008. Banking leaders reiterated yesterday that they continue to provide access to credit and support their consumer and business clients. Overnight lending is orderly with the New York Federal Reserve providing additional liquidity to support capital flows. Essential to healthy functioning of capital markets is the bridge to recovery being built by the Federal Reserve and fiscal policy makers who have committed to doing ‘whatever it takes’ to support the U.S. economy. Targeted support of companies and individuals most impacted is essential.

  • Phase III: Bottoming - Price action this week is reflective of price overshoots that start to form the basis for a technical bottom (i.e., price support). Great assets are sold indiscriminately along-side more challenged ones. Fundamental analysis seeks to value assets looking through the period of uncertainty as opportunities unfold.

  • Phase IV: Spillovers - There are inevitably longer term implications from an exogenous shock like COVID-19. Short-term challenges evolve into longer-term lessons that should better prepare leaders in the future.

The next few weeks will be critical in getting clarity on the breadth and pace of the virus transmission and the resulting impact on businesses and jobs. With the Federal Reserve meeting on Wednesday, March 18, additional monetary stimulus is expected. Fortunately, we are entering this challenging period economically strong. Unemployment is near record lows, consumer spending (pre-shock) has been healthy, and consumer debt service ratios (i.e., payments as % of income) are at the lowest levels since 1980. 3

Those countries whose virus transmission preceded us are being rigorously analyzed. Fueled by drastic ‘social distancing’ actions, COVID-19 transmission appears to have declined in multiple regions including China and the evolving situations in Hong Kong, Singapore and possibly Japan. This precedence likely catalyzed the temporary travel ban on Europe with a goal to cut-off the spread of the virus and truncate the duration of the economic shock. While painful in the short-term, this approach may foster economic recovery sooner and save human lives.

U.S. COVID-19 testing is accelerating. While initial testing was slow, COVID-19 tests are now available in every state with 1 million tests distributed to date and 4 million more expected by Friday.4 As testing increases, we expect more cases will be discovered and the potential for tighter activity restrictions managed at the state level.

News flow is expected to deteriorate in the short term. The financial market, as a leading indicator, is increasingly pricing that in.

Looking through this period of uncertainty, we find some silver linings.

  • We expect pent up demand is building and could fuel a powerful rally when virus transmission subsides.

  • Lower interest rates and lower gas prices can provide powerful economic benefits to consumers and businesses.

  • Chinese production is restarting; while activity levels are still low, they are expected to be closer to normal by early April.5

  • Monetary and fiscal policy leaders are committed to supporting the economy and building a bridge to recovery.

  • Valuations for exceptional companies have contracted creating compelling opportunities for long-term investors.

The U.S. equity market is now pricing in recession; the closest parallel may be 2001, a year in which we had two quarters of negative growth as we climbed our way out of the 9/11 shock. Looking at rebounds in S&P 500 performance six months post the trough in the last six event-driven bear markets, the median price recovery was 21%; in 2001, it was 29%.6

It is important to remember the following:

  • Over 90% of the value of stocks is dependent upon profits more than 12 months out into the future. 7

  • Most viruses are self-limiting; a rebound into 2021, and perhaps sooner, is possible.

The rewards of staying invested through periods of volatility cannot be understated. If you had invested in the stock market from 1999-2018, and not touched it, your money would have tripled. If you had traded in and out missing just the 10 best days over that period, your returns would have been cut in half. Six of the ten best trading days occurred within two weeks of the ten worst days. 8

We are closely watching valuations seeking asymmetric payoffs; opportunities are increasing in both equity and credit markets. For long term investors, financial markets are increasingly brimming with opportunity.

Invest in You. Trust in Us.

Footnotes:
1 – El-Erian, Mohamed A., The Four-Stage Impacts of the Coronavirus, Bloomberg, 2/27/20
2 – U.S. Equity market is defined as the S&P 500
3 – Debt Service Ratio = Debt Payments as % of Disposable Personal Income, J.P. Morgan, Guide to the Markets
4 – Whitehouse.gov / briefings / Press Briefing by Vice President Pence and Members of the Coronavirus Task Force, 3/10/20
5 – Tilton, Andrew, Goldman Sachs, SARS-Coronavirus-2 and the Economic, Investment, and Political Implications
6 – Goldman Sachs Investment Research, 2020 Earnings Recession Imperils Bull Market, 3/11/20
7 – Siegel, Jeremy, Stock Shock: What Lies Ahead for Global Markets?
8 – O’Brien, Sarah, Here’s What Can Happen If You Flee The Stock Market For Cash

Any opinions are those of Financial Advisors Catherine Trinder-Miller and Theresa N. Benson, CDFA and not necessarily those of Raymond James. The information contained in this article does not purport to be a complete description of the securities, markets, or developments referred to in this material. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete. It is not a statement of all available data necessary for making an investment decision and does not constitute a recommendation. All opinions are as of this date and are subject to change without notice.

Past performance may not be indicative of future results. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses, which would reduce returns.

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