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.