Mark Hulbert made a terrific point last week. The coronavirus was not the real reason for the market sell-off. The real reason was excessively bullish sentiment. The coronavirus news was just the excuse.
That real culprit is market sentiment: Short-term stock market timers, on balance, have been extraordinarily bullish for a couple of months now. Even a few days of such excessive bullishness would normally lead to market weakness, much less a few months of such exuberance. So conditions were ripe for a pullback.
If it weren’t the coronavirus, in other words, something else would have been the straw breaking the camel’s back.
I had made a similar point in the past. Fast money positioning had become too extreme. Readings were at a crowded long, and portfolio leverage was highly elevated. The market was just ripe for a bearish catalyst.
In that case, how should you react to the coronavirus pullback?
Short and long-term outlooks
The answer depends on your time horizon. While I am not blind to the human effects of a possible pandemic outbreak, the purpose of this publication is to analyze the investment impact of such events. Ray Dalio of Bridgewater Associates recently outlined the issues well in a recent essay.
As for the spreading of this virus, as with any sort of unknown, there are 1) actual events and 2) the expectations of events that get reflected in market pricing. Generally speaking these once-in-a-lifetime big bad things initially are under-worried about and continue to progress until they become over-worried about, until the fundamentals for the reversal happen (e.g., the virus switches from accelerating to diminishing). So we want to pay attention to what’s actually happening, what people believe is happening that is reflected in pricing (relative to what’s likely), and what indicators that will indicate the reversal.
In other words, what are the risks? In the short run, here are the questions that investors need to answer:
- Economic slowdown: Market base case is the SARS outbreak. Will the actual be better or worse?
- Trade tensions: How will the coronavirus outbreak affect China’s ability to make the purchase committed to under the Phase One trade deal, and how will the US respond?
- Other excuses: If the market was just overbought, are there other excuses for it to go down?
In the longer term, how does the coronavirus outbreak affect the global growth outlook?
Since we are mostly in uncharted waters, a first order approximation of the effects to GDP growth is the SARS outbreak, whose effects were felt most acutely in Hong Kong, and the nearby Chinese province of Kwangtung.
However, there are a number of key differences between the SARS episode of 2003 and the Wuhan coronavirus epidemic of 2020.
China is a much bigger part of the world economy today. Disruptions in China today has a much bigger disruptive effect on the global economy because of its participation in global supply chains, as evidenced by the numerous announcements of overseas companies either curtailing or shutting down their operations in China. A partial list include household names like Starbucks, General Motors, Ford, Nissan, Apple, Honeywell, and Ikea.
As well, the government’s lockdown of activity during the Lunar New Year has cratered Chinese consumption, which is a much bigger portion of the Chinese economy today compared to 2003. As an illustration, box office receipts have cratered to zero during this period.
Another key difference between 2003 and 2020 is the increased level of debt in China, which makes that economy more fragile and vulnerable to unexpected shocks.
Comparing SARS and the Wuhan coronavirus can be problematical in other ways. There is some good news and bad news here. The bad news is the coronavirus infection rate is much higher than SARS.
The good news is the fatality rate is much lower. The SARS fatality rate was about 10%. Initial estimates of the Wuhan coronavirus fatality rate was 2-3%, but it is likely to fall further because of the higher reported infection rate.
Even then, the combination of high infection and low fatality rates have caused concerns at the WHO. The mildness of the virus could help it spread undetected until it reaches a highly vulnerable population. This may be the kind of virus that makes people sick enough so that it spreads, but not so sick that the infected are noticed by health authorities. So far, most of the infected countries are classified as either “most prepared”, or “more prepared”. What happens if the virus migrates to a country that is least able to deal with such outbreaks?
As an example of the effects of different levels of preparedness, a recent WSJ article documented the differences in response between two Canadian cities, Vancouver and Toronto, to the SARS outbreak.
In Vancouver, by contrast, “a robust worker safety and infection control culture” enabled the hospital to contain the virus, the report found. The Vancouver man with SARS felt ill after a trip to Asia and went to the hospital. Because of his symptoms, the staff whisked him out of the crowded ER within five minutes. Caregivers wore tight, moisture-proof masks and disposable gowns to protect themselves.
The same evening, the Toronto man, whose mother had come from Hong Kong two weeks earlier, went to the hospital with feverish symptoms. For 16 hours he was kept in a packed emergency department. His virus infected the man in the adjacent bed, who had come to the ER with heart problems, and another man three beds away with shortness of breath. Those two other men went home within hours but were later rushed back to the hospital, where they spread the virus to paramedics, ER staff, other ER visitors, a housekeeper working in the ER, a physician, two hospital technologists and, later, staff and patients in the critical-care units.
Poor adherence to infection-control protocols was to blame. Staff failed to wear masks and disposable gowns and didn’t wear face shields while inserting breathing tubes down patients’ airways. After the initial Toronto patient was finally admitted to a hospital room, it took five more hours for him to be isolated.
American hospitals, which are ranked as “most prepared”, have their shortcomings:
A June 2017 literature review of shortcomings in U.S. emergency rooms found a lack of adequate distance between patients, use of contaminated equipment, failure to use shields to protect health-care workers who are intubating patients, and failure to ask coughing patients to wear masks…
The CDC conducted “mystery patient” drills at ERs in 49 New York City hospitals, sending in 95 patients pretending to have symptoms of measles and Middle East respiratory syndrome. In 78% of cases, the ER staff gave these patients masks and isolated them quickly. Even so, only 36% of health-care staff washed their hands. The CDC found “suboptimal adherence to key infection control practices.”
The nightmare scenario is the Spanish Flu of 1918, which killed millions. The effects of the Spanish Flu was exacerbated by poor sanitation and containment protocols. Already, the virus was identified in India, which could be an at-risk country because of its vast population and uneven healthcare standards. What if it shows up in the countries marked as “least prepared”?
So far, the Chinese government has gone all-in with relatively draconian quarantine measures to combat the spread of the virus. This is in stark contrast to the initial response of denial during the SARS outbreak. While policy response and transparency is positive, which the market values, perceptions could easily turn negative at any time. (Recall Ray Dalio’s comment about “what people believe is happening that is reflected in pricing”). However, the government’s public response could turn defensive if unflattering questions and news articles start to emerge. Consider as an example this New York Times opinion piece which concluded that the government cannot be trusted:
Behind all this lies the feeling that most other people in the party can’t quite be trusted. This has been reinforced over the past few days by reports that at least eight people who were detained in Wuhan in early January on charges of spreading rumors are in fact medical doctors, not fear-mongering ne’er-do-wells. This startling fact is now leaking out in online reports that are sometimes, but not always, being blocked. At some point, the government will have to admit to a partial cover-up.
Considering the underlying distrust, it’s hard for the government to say what many epidemiologists are saying: This outbreak is serious but not catastrophic. Because if the state leveled with the people, it would also have to admit that there is no need for this degree of social control. Fewer than 200 people were reported to have died as of Thursday evening, in a country of nearly 1.4 billion, and there is no indication that we are at the start of a Hollywood disaster-style movie.
The government’s inability to formulate a measured response will turn this outbreak into a direct successor of the SARS epidemic. That hardly was a huge public health disaster — fewer than 800 deaths — yet it has taken on a legendary reputation as a catastrophe of unimaginable proportions, one that should never be allowed to recur.
Anything that threatens the authority of the Party is a threat, and the standard Chinese response would be censorship, which would rattle the markets as they hate uncertainty. Imagine the following scenarios (and to be clear, they are made-up and speculative) where questions are asked:
- Stories circulate of drug-like deal behavior for surgical masks and other medical supplies that the authorities either turn a blind eye to, or unable to control.
- Embarasing questions about the government’s response to a coronavirus outbreak in Xijiang, and the uneven healthcare provided the Uighur population, compared to the majority Han Chinese.
We would go into the second phase of the fight against the virus, where a veil of censorship goes up, and the world becomes unsure of China’s ability to control the outbreak.
For now, the base case adopted by most analysts is one quarter of very soft or negative GDP growth, followed by a rebound as the virus scare burns itself out. At this point, these are only guesstimates, and investors should monitor how the consensus shifts in the future.
Political and electoral considerations
Another key question is how the US will react to a Chinese slowdown. The Phase One targets of Chinese imports of American goods were already very ambitious. Any soft patch in Chinese growth, even if it’s confined to just one calendar quarter, will make them impossible to meet. How will Trump react, especially in an election year when he is politically pressed to show progress in a trade war? Will trade tensions rise again?
As well, I began this report with the thesis that the market was ready to fall, and the coronavirus news was just an excuse. Supposing that news begins to emerge that the outbreak is becoming well contained, could the market still go down?
The answer is yes. There are other threats that could rattle the markets. The Iowa caucus is coming up next week, to be followed by the New Hampshire primary the following week. The latest PredictIt odds now show Bernie Sanders in the lead to win the Democrat’s nomination for President.
Would that be enough to spook Wall Street? You bet!
The long-term outlook
Looking out longer term, the outlook is much brighter. There are numerous indications that the global cyclical rebound scenario that I outlined is still valid (see How far can stock prices rise?). The market should be able to look through the valley of a one quarter hiccup to Chinese and world growth under the base case coronavirus scenario.
Consider, for example, this Gavyn Davies FT article, “Signs of a global recovery in manufacturing are starting to show”. Davies referred to the Fulcrum nowcast, which has unambiguously turned up. He did, however, add the caveat of an assumption that “there will be no meaningful impact on GDP from the coronavirus”.
There are also other numerous signs that the cyclical revival is still alive and kicking last week (see How my Sorcerer’s Apprentice trade got out of hand), so I will not repeat myself here.
In the absence of definitive recessionary signs, these indications of a cyclical rebound are bullish for the long-term equity outlook. In the short run, however, prices may have gotten ahead of themselves and the US market is overvalued.
How overvalued? The Rule of 20 provides some guidance. Recall that the Rule of 20 flashes a warning sign whenever the sum of the market’s forward P/E and the CPI inflation rate exceeds 20.
At a minimum, how far does the market need to correct for the Rule of 20 indicator to fall to 19.9? Based on today’s headline CPI inflation rate of 2.3%, and my forward 12-month EPS estimate of 178.71, the S&P 500 would have to correct to at least 3145 before the Rule of 20 sound the all-clear signal. This represents a peak-to-trough correction of about -5.5%. However, the historical evidence shows that the Rule of 20 indicator has fallen much further in the past before bottoming. In other words, pencil in a 5-10% peak-to-trough correction.
However, investors can find cheaper valuations outside the US. While the forward P/E of the US market is at nosebleed levels, developed market P/E ratios are more reasonable at about 14, and EM equities is trading at a forward P/E of 12.8. In the short-term, however, I would avoid EM because of their exposure to China and the uncertainties associated with the coronavirus.
While the above chart shows the valuation differential between US and non-US equities, the following chart illustrates the tactical price differential. US stocks have surged on a relative basis against MSCI All-Country World Index (ACWI), while non-US stocks have all tanked by comparison.
In conclusion, traders and investors need to consider their time horizons in order to navigate the latest coronavirus panic. In the short run, the market is falling because of excessive bullish positioning, and the risk-off unwind is not complete. There is more unfinished business to the downside for equity prices.
Longer term, I believe that the global growth outlook remains intact. Investors with longer time horizons should use any market weakness to add to their equity positions. In particular, they should focus on non-US markets, which are more reasonably valued.
In other words, buy the dip, but not yet.
Disclosure: Long SPXU