In reading various analysts’ reports over the weekend, the coronavirus is credited with the drop in the US equity markets as well as many other markets around the globe.
In our opinion, the US market had paid little attention to the virus until it had notably spread outside China. This past week, the S&P 500 fell 11.5% and the Dow Jones Industrial Average (DJIA) tumbled over 12%. To put these declines into perspective with other major market declines; on Black Monday in 1987, the DJIA fell -13.2%, in 1929 it crashed -13.5%, the Dot.com collapse in 2001 was -14.3%, the 1933 Great Depression was a crushing -15.6%, and after Lehman Brothers collapsed in 2008, the DJIA sank -18.6%.
While it is easy to point to the virus as the only reason for the market decline, there are other factors that likely contributed to last week’s large decline. First, we must not forget we have been in one of the longest bull markets in history, lasting over 12 years. Valuations, as measured by the P/E ratios, were at 19 times versus the historic market average of 15 times. Last year’s corporate earnings excluding share buybacks fell while the market multiples increased. The S&P 500 grew at just a 2.9% on a pre-tax basis over the last decade. In the 5 years through 2018, economy wide business profits were essentially flat, according to the Bureau of Economic Analysis of the Department of Commerce. Over the same period, the S&P 500 produced compound annual returns of 6.3%. (Grant’s Interest Rate Observer, January 2020). Without the earnings to support historic high valuations, the market was in dangerous territory. This is where the virus comes into play. With China as the epicenter of the virus having the majority of the cases and deaths, Chinese manufacturing has all but shut-down in many sectors causing serious supply chain disruptions to those who rely on Chinese components for finished products. This will hurt tepid earning expectations. The likelihood that the market continues to trend higher will diminish as earnings stall.
That gives rise to a second factor, renewed fears of a recession in the US. Falling earnings and slowing exports caused by trade wars, coronavirus, and slowing consumer spending will dampen economic growth expectations. The idea of a recession recently thought to be postponed to 2021 may become a reality in 2020 as economic activity slows and grinds to a halt. If coronavirus cases and deaths are increasing, the more likely we are going see a recession sooner rather than later.
A third factor is the rise in the polls and the success of Bernie Sanders. A little over a week ago, Bernie was the frontrunner and likely thought to have a real chance to secure the Democratic nomination with success in the first three primaries and his increasing popularity in recent polls over his more centrist opponents. Bernie’s socialist agenda is alarming many investors, especially foreign investors who have first-hand experience with socialist regimes. The US is viewed as a strong bastion of capitalism with an entrepreneurial environment in which to invest. While the results of Super Tuesday indicate Biden as the frontrunner, if Bernie is successful at first winning the nomination and then beating Donald Trump, many positive economic initiatives would be reversed.
Just over one week ago, there was an 11% chance that the Federal Reserve was going to cut its target interest rate at the next meeting on March 18. On Tuesday, March 3, following the days of financial and economic fallout over the coronavirus, the Fed announced its first emergency rate cut since 2008, cutting the benchmark interest rate to just below 1.25 percent, down from 1.75 percent. The target interest rate has been steadily rising since the 2008 crisis and now the Fed has been forced to reverse course. With this accommodative monetary policy, each rate cut leaves less room to further lower rates to stimulate the economy. Looking to Europe, the entire German government bond market, even 30-year bonds, have negative yields and the German economy grew .6% in 2019. As the fourth largest economy in the world, with negative interest rates, they narrowly avoided entering a recession.
The last US recession was in 2008 and we are overdue for another. Expect more volatility if the news concerning coronavirus dominates the news cycle. Recessionary fears will fast forward as the economic growth stalls and markets are not likely to bounce back as quickly as hoped until investors see a recovery in earnings to support valuations. We are currently seeing a brief interlude from the coronavirus story as the democratic Super Tuesday commands attention from the media providing some clarity as to whether the centrists of the party still have sway or if the left is in complete control. The Democratic convention will likely settle the issue, and no one should be surprised if we see a brokered convention.
With the convergence of many factors and no clear resolution in sight, we may have to wait until after the US election for return of market stability. This is assuming that in the coming months, the coronavirus is under control and economic activity has resumed. Let’s hope that this will be the case. In the interim, we will be closely following the markets and any developments related to the coronavirus.
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