I have started this note at least three separate times and each time something happens that changes the tone of what I want to write. I know this is a very scary and confusing time for everyone. It seems like our world is about to come to a halt. Nothing could be further from the truth. Amid this maelstrom, we need to remain calm and think rationally. I would like to let you know what I am seeing and thinking about our current economic situation.
I wrote to you just a week and half ago regarding the volatility we were seeing the markets at that point. At that time, I indicated that the COVID-19 coronavirus epidemic was a serious event but that much depended upon how we and the rest of the world managed to contain the spread of the virus. I felt that if we managed to effectively gain some measure of control, this market turmoil would turn out to be little more than a market correction. In the interim, we have had more information to come out – both about the epidemic or pandemic now as the WHO has labeled this crisis and in the completely different world of oil. Let me address each of these separately and then bring the two together.
Looking at the ongoing saga of the COVID-19 coronavirus, it turns out that the U.S. is behind the curve in containing the virus. One of biggest issues was a severe shortage of test kits available in the U.S. to test people who may have been exposed to the virus. There were several failures along the way here but pointing fingers and trying to lay blame does not resolve the situation. The truth is the U.S. was ill-prepared for the virus to hit our shores and the current administration attempted to minimize the severity of the situation, likely to prevent a panic. That has obviously backfired spectacularly if the stock market is any indication. As President Trump spoke on Wednesday night, in an attempt to offer up solutions to deal with the virus and the economic fallout, the futures – the expectation for how the U.S. stock market will trade the following day – moved from up 200 points to down 1,100 points. This shows a remarkable lack of faith in our government’s response to the crisis.
In its defense, the U.S. has ramped up production of test kits. They are more available now, but we are currently only testing people who are walking in to clinics or hospitals complaining of possible symptoms. If we want to contain this virus, we need to do far more testing. We can stem the tide by finding those who have milder symptoms and are contagious to stop them from playing “Typhoid Mary”. We can also keep social distances, avoiding large crowds and staying home when sick. How all of this will play out, I have no idea but that is not my job. Rather, that is something that I had expected to hear from our President.
Before I get to my next point, I want to be clear that I am not a doctor, nor do I play one on TV. However, I do know some doctors and I went straight to one of them for information on the COVID-19 novel coronavirus. Coronaviruses have been around for a while, but what we are seeing now is a new strain of this virus that has never been seen in humans before. That is why we call it a “novel” coronavirus and the “19” indicates the year it was first diagnosed in humans. The symptoms around this novel coronavirus include runny nose, sore throat, cough, fever and difficulty breathing. Since this is a new mutation of the coronavirus, no one has any natural immunity to the virus making this very contagious.
This is where the media steps in to whip up the fear. Based on the number of people who have died from this virus here in the U.S. relative to the number of diagnosed cases, you might think the death rate is north of 5% of the population. If you look at the death rate in China, where this virus was first diagnosed, it was around 3.5% of the population of diagnosed individuals. And that last part of the sentence is the key part – diagnosed individuals. In large part, only people who showed symptoms were tested. We don’t know how many more people had the virus but it passed reasonably quickly and without major incident for them. South Korea may be a more accurate picture of what we can expect. South Korea tested over 140,000 people and the death rate from those with the coronavirus was around 0.6% of the confirmed cases. This was because more people had been exposed to the COVID-19 coronavirus than anyone thought, but many of them had more mild cases which cleared up with time and treatment.
I do not want to minimize the risks of this new virus or dismiss the need to take precautions. While the media is busy hyping the severity of this virus, many are screaming and pointing to the flu and saying “but what about…” Both are serious business. There are key differences, though. One is that there are vaccines to help control the flu virus. In addition, most flu viruses have been around long enough that many people have built up a natural resistance to them. Since this novel coronavirus is a new strain no one has any natural immunities built up yet. Also, with no vaccines to help control it, there is a real risk of it spreading rapidly and widely throughout the population. With a still limited number of test kits available currently, getting diagnosed will largely depend upon whether or not you have traveled to a region of the U.S. or world where the virus is prevalent or whether you have been exposed to someone who has been diagnosed with the coronavirus. As per my source, if you have milder symptoms, stay home and call your doctor. If you have slightly more severe symptoms – fever, cough – you might seek out a walk-in clinic. Leave the ER visit for those who are at the most risk.
And that last part is where we do need to be concerned and a bit alarmed. One of the biggest issues around this coronavirus is the constraints on our healthcare system. Since this is a highly contagious virus, many people are likely to be infected. The people who are most vulnerable are the elderly and those with compromised immune systems or chronic health issues. If this spreads rapidly enough, the number of people needing to be treated could overwhelm our healthcare system. You could potentially have dozens of people walking into an ER or clinic that is operating short-staffed because a number of the healthcare workers are home with the coronavirus themselves. In addition, if the patients coming to the ER need treatment due to already existent health issues, there is a very real possibility of a hospital not having the room or proper facilities to treat that patient as their equipment may be already tied up with someone else.
It is for this reason – the need to slow the spread to keep from overwhelming our healthcare system – that events are being cancelled and businesses are urging employees to work from home. This “social withdrawal” is one of the best ways to slow the spread of the coronavirus. Following such procedures as washing your hands and not touching your face will also help. I still believe the damage to our economy from having the NCAA tournament cancelled or the cancellations of festivals and conferences will be a short-term blip. The economy may show zero or even negative growth for a quarter or two, due to measures now being taken to control this coronavirus, but we can and will recover quickly from this setback.
The bigger issue for me came last weekend when Saudi Arabia suddenly reversed course on trying to limit oil production in order to bolster the price per barrel. Essentially, the OPEC nations and Russia were in discussions on ways to cut production and keep the price of oil at a reasonable level for all of them. There were some disagreements on the level to be supported and Russia and Saudi Arabia both walked away mad. To get even, Saudi Arabia immediately lowered the price of oil they are offering to sell to China by $6 per barrel, undercutting Russia and effectively cutting them off. This led to a very severe drop in the price of crude oil as it fell from $41 per barrel on Friday to $31 per barrel last Monday. Why is this concerning? After all, lower oil prices will mean lower gas prices at the pump and that is a good thing for the economy, isn’t it? Well, yes that part is good, but the timing is terrible and such a dramatic fall has repercussions well beyond lower gas prices.
This is, in part, where the two stories – the coronavirus and the oil shock – come together. While lower oil prices will lead to lower gas prices, it is coming just at a time when events are being cancelled or postponed. The lower gas prices will have only a marginal effect on the economy if most people end up “self-quarantining” themselves to slow or prevent the spread of the coronavirus. If the oil war continues through the summer, this offers a small benefit to consumers. However, the longer this oil war drags on the worse it will be for oil companies.
Many U.S. oil companies are very highly leveraged, meaning they have borrowed a lot of money over the years. Many of these companies need for oil to sell for $32 per barrel in order to at least break even. Above that price, these companies make money. Below that and we have serious trouble. If oil remains at $30 per barrel or less, some of these oil companies will start trying to cut costs to save money. This will mean reduced drilling efforts which will mean some employees and suppliers will lose jobs and money. Eventually there will be layoffs and that will lead to layoffs by businesses that rely on the money these workers bring in.
I mentioned in my last update that I was not terribly worried about a long-term economic impact from the coronavirus. I felt any impact would be sharp but short-lived. I felt – and still feel – that companies will return to business as usual in short order as panic over the coronavirus gradually fades. Yes, Disney is closing its theme parks for a couple of weeks, but do you really think people will stop going to Disney as summer rolls along? It may take a few more weeks after reopening for people to venture back out. Eventually the parks will be packed again, and Disney’s earnings will return to normal. What I did not count on in my last note was the oil war that exploded almost literally overnight. That, along with a weak response to the coronavirus here in the U.S. has changed my outlook. I am now expecting a recession if we are not already in one. The thing with recessions, it is usually only after economists look back on key numbers that we recognize when they started.
Given this change in my outlook, I will be making some changes to client portfolios. I will be shifting from a focus on “growth” to a focus on “defensive”. Most recessions can last from twelve to eighteen months. Just because we enter a recession does not mean that stocks will not go up in value. There will always be companies that will benefit from the trials and tribulations of others. As I mentioned in my last note, I was already preparing a shopping list. Honestly, it wasn’t until I changed my focus on where I wanted to look for stocks that I was able to begin to find any value. This does not mean that you should give up on stocks completely. Over the longer term, stocks will do far better than any other asset class. As I mentioned before, for many of you that are in retirement, we have four years’ worth of your required minimum distributions in bond funds. This buys us the time to allow the stock portion of the account to bounce back. If you are not in retirement and not close yet, this is a time to think about investing more. If you have a 401(k) where you work, perhaps increase your contribution and “stay the course” with an allocation you are comfortable holding. At the very least contribute enough to get your employer’s maximum matching contribution if they offer that benefit. If you are maxing out your 401(k) contributions, consider IRA’s or even taxable accounts. Buying when things look bleakest leads to the biggest gains when all looks brightest.
If you are close to retirement – within the next two or three years – or if you are worried by the market volatility, perhaps you should consider changing your allocation. If you have specific questions about how to reallocate or just want to talk through whether you should reallocate your account, please feel free to call me or email me at your convenience.
As one last side note, when I started writing this note it was in the middle of the day when we were experiencing a 9% loss and one of the largest sell offs since the 2008 financial crisis. As I finish writing, we have bounced back by just over 9% for the day, one of the biggest up days since the 2008 financial crisis. Please do not think things have changed for the better over night and we are heading back to new records. I fully expect more volatility in the days and weeks to come. There will be news of companies losing money or potential bankruptcies that will roil markets. There will be successes like Congress passing a bi-partisan bill that helps cover many of the shortfalls for people out of work due to the coronavirus. The bigger key is whether we bounce back quickly and, more importantly, how things play out with oil and the oil companies. I do have a shopping list of stocks I would love to buy, and I am constantly updating it with new information. This list will likely change over time and I am in no hurry to buy just for the sake of buying. As Warren Buffett has pointed out, we don’t have to swing at every stock that is pitched at us. We can patiently wait for the “fat pitch” that is easily knocked out of the park. And, switching metaphors, just because we miss one investment train is no reason to get upset. There will be another one coming along at some point.
COVID-19 and Market Volatility
By now, everyone is probably aware of two things – there is a new disease called the Covid-19 coronavirus and it is not caught by drinking Corona beers. The stock markets fell 12% in just four days which was a record and the worst week since October 2008 during the financial crisis. These two events are very much related. I just wanted to touch base with you to let you know what has happened and what we are doing around this situation.
In my last quarterly letter, I did preach caution. I also mentioned the threat of exogenous events and this strain of the coronavirus and the potential for this to turn into a pandemic certainly qualifies as an exogenous event. With that in mind a market meltdown does not guarantee a recession. Stock markets will have corrections all the time. I would call this a correction. What this does is bring us back to reality. I really felt the stock market had gotten well ahead of itself – rising 30% over last year with very little earnings growth as support. In the world of investing, there are some ratios that many investors track. One of these is a price-to-earnings ratio. This is simply the price of a share of stock (or index) divided by the earnings attributed to one share of stock (or one share of the index). This ratio tells you what investors are willing to pay for one year’s worth of earnings. If a company earned $1 per share over the past year and investors are willing to pay $10 for a share of the stock, this is a price-to-earnings or P/E ratio of 10. By itself, this tells you nothing but looked at over time, you can see trends. Looking at the S & P 500 Index, one of the more popular measures of the broad stock market, the P/E ratio on this index was 14.6 at the end of 2018 and 20.4 at the end of last year. This means investors were only willing to pay $14.60 for $1 worth of earnings at the end of 2018 but were willing to pay $20.40 for that same $1 worth of earnings at the end of 2019. In other words, investors were willing to take more risk – paying more for the same amount of earnings than the prior year.
What does all that mean and just exactly how does that relate to the coronavirus? Great question! Let me explain why this coronavirus is wreaking such havoc. Let’s start with the fact that the virus started in China. In response to the outbreak Chinese officials largely shut the country down. When it was first discovered it just happened to be during the Chinese New Year holiday. Everything shuts down in China for this celebration. In response to the virus, China extended their holiday during which all businesses were shut down. Even with this response the virus spread, and China shut down travel between all provinces and essentially put large sections of the country on lock down. As you probably know most U.S. companies have outsourced at least some part of their manufacturing to China. With these shutdowns in place, factories were closed effectively halting production. In addition, with the country effectively shut down, commerce ceased. No one was shopping except for essentials. The anticipation is China’s economy essentially had zero growth for this quarter.
The virus has since spread from China to every continent except Antarctica. We have learned that an individual can be contagious for up to 14 days before showing any symptoms. This has complicated responses to this virus. When new cases appear, the first response is to try to track the movements of the infected individual over the prior two weeks to see who else may be infected. This is prompting great fears of a coming pandemic and a worldwide response like China’s – shutting down everything until the virus is contained.
With China’s economy accounting for almost 20% of the global economy, any dramatic slowdown will have ripple effects. Further, the fact that supply chains for many U.S. companies were closed for several weeks will lead to lower sales of products here in the U.S. Apple, for instance, has already warned investors that due to “constrained” iPhone supply out of China and store closures in China, the company would not meet analysts’ expectations for their second quarter’s earnings. This scenario is playing out throughout the U.S. and the world. All of this is leading to the fear of the big “R” word – recession.
I do not think we are at the tipping point of a recession just yet. Much will depend upon how quickly the U.S. and the rest of the world can contain this virus. Right now, everyone is operating on fear. This fear is leading to people panicking and selling stocks and buying U.S. Treasury bonds (a very safe investment) and gold (another investment viewed as safe during times of crises). However, all the market losses are not solely due to coronavirus fears. These fears lead to selling but these sales drive prices down which trigger some automatic sell programs large advisors have in place. Add to that traders who try to take advantage of momentum by selling short – that is selling stocks they don’t own hoping to buy them back later at a lower price – and you have a recipe for panic selling.
What has not helped is that many companies are currently releasing their annual earnings reports for last year. In conjunction with these releases, companies tend to provide forecasts of their expectations for the coming quarter and year. Companies are no longer offering guidance for the year citing the uncertainty over the coronavirus. Without some idea of what a company may earn for the next year, it is hard for an investor to assess whether the stock is priced fairly or not. Returning to the P/E ratio I mentioned earlier, if I am willing to pay $18 for each $1 worth of earnings and I have a reasonable expectation a company may earn $5 per share next year, I would be willing to pay $90 for that stock. If the company tells me they now have no idea what they may earn, I am less willing to pay that $90 and may choose to pay a lot less - $75 or even $50 per share rather than the $90 I had been willing to pay.
What is going to stop all this selling? There are two things. One will be how quickly countries around the world manage to contain this virus. If new cases of the coronavirus hit a peak and start falling, this will be a sign that countries are starting to contain the virus. This seems to be happening in China currently, though the country is still not back to normal operations yet. However, other countries are only starting to see new cases pop up and these cases could spread to other countries. The other thing that will stop the selling is when prices have fallen far enough that investors feel like stocks are a bargain again and buying begins to outpace selling. I remain convinced that we are not on the verge of a recession – yet. I suspect the Federal Reserve, which sets interest rates for the U.S. economy, will cut their interest rate in mid-March in an attempt to forestall a recession. If countries can contain the virus reasonably quickly – within the next couple of weeks – our economy should bounce back from this current slowdown. If investors perceive this outcome, stock prices are likely to rebound though not necessarily straight back to recent highs.
If it takes countries longer to contain the virus this would be very detrimental to the global economy. There is already talk of cancelling the 2020 Olympics which are to be held in Tokyo this year. This would be just one step towards a global recession that would likely keep U.S. stock prices at depressed levels for a while. If new cases continue to pop up around the globe, especially in large numbers, over the next couple of months global growth would likely turn negative and this would likely tilt the U.S. towards a recession either later this year or early next year. I am paying close attention to developments not only with this coronavirus but also economically both here and abroad.
As long as this sell off is simply that – a market correction – I am not worried. Stock prices may not rebound immediately but they will recover from a correction. In a best-case scenario, we are probably talking weeks rather than months, but this is no guarantee. I have taken a few steps and will likely take a few more. I made several attempts to purchase put options – options that rise in value as stock prices fall. I was finally successful on Tuesday. By Thursday, I was closing out some of this position at a profit and closed out the last of these options early on Friday morning. We ended up with a decent profit across the board from these options transactions which helped offset some of the losses from the stock and equity mutual funds we own. We also have a reasonable allocation to bond funds which hold up well during volatile times like this. For several of you who are in retirement, I have added a couple of additional bond funds that lock in your estimated required distribution for the next couple of years. With a higher allocation to bonds that preserves capital, this buys us some time for markets to rebound. Lastly, much like everyone else, I am developing a “shopping list” of stocks that I would like to own if the price is right. Rest assured that I am keeping a very close eye on this situation.
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