Ignoring Bad News
Stock prices, measured by the S&P 500, fell 7.48% in February. This leaves them down 7.52% year to date. While a difficult start to the year, these figures mask the true story. On February 19th stocks set a record high and by month end had dropped nearly 13%. According to Bespoke Research, the S&P 500 fell over 12% in the six sessions ending on Thursday February 27th, its fastest drop from all-time highs, ever. The selling volume was the highest since August 2011, when Standard & Poor’s rating agency cut the U.S’s credit rating to AA+ partly due to dysfunctional policymaking in Washington.
As you know, the panic in the markets is tied to the coronavirus. A dozen epidemics have struck, dating back to the HIV/AIDs crisis in June 1981. All induced immense fear and reciprocal selling on Wall Street, but within 6-months the stock-related implications of the epidemics had been resolved. What we saw in February is a market that had gotten ahead of itself, largely through ignoring bad news, forced to re-price as the fear of the epidemic to both the supply side and the demand side of the economic equation began to pencil out.
It is interesting that over the last two years, stock prices have produced some alarming volatility. Back in the early days of 2018, prices fell roughly 10% due to the imposition of Trump’s tariffs. Beginning that fall, prices began an extended downslide, falling nearly 19% by Christmas. This was primarily attributable to the Federal Reserve as it was attempting to normalizing interest rates. Then, just last week, prices fell nearly 13% in less than a two week span over fears of the global spread of the coronavirus. The volatility does not seem as though it will abate any time soon, and investors will likely begin to lower stock exposure, or demand higher returns, if these dramatic price swings remain this challenging.
The recent price swings are investor’s attempts to price in the longer-term impact of the virus. Investors overcome with fear are using worst case assumptions. On Wall Street, fear is contagious. There are several things we can observe from the market’s recent behavior. First, stock prices tend to rise gradually and fall quickly. We are in a computer driven world and much of the trading that takes place on Wall Street is handled by algorithms, versus pencils and green eyeshades. Also, the recent prevalence of ETF’s creates a flywheel effect and both selling and buying become accentuated well beyond what the market might normally dictate. It’s impossible to accurately link the potential severity of the coronavirus with future stock market levels.
I expect the fear factor will crest and countries will better implement mechanisms to defend their populations. Sadly, this may exacerbate the already anti-globalist tendencies. There will be an impact on the stock market, separate from the recent emotional rash of selling; analysts’ earnings forecasts will come down as expectations are lowered. This will be due to supply chain disruption and demand reduction (airlines, for example), putting a fundamental cap on expected returns from stocks in 2020.
Going forward, we should anticipate increased pressure on the Federal Reserve to lower interest rates in an attempt to spur economic growth –primarily by boosting stock prices. As we saw in 2019, forced liquidity can artificially lift the market multiple, pulling prices up, without any underlying change in business economics. Investors had been hoping a 10% surge in corporate earnings would drive stock prices to new highs. Now, with the unknown scope of the virus weighing on investors, the market is discounting low to no growth and the focus will shift outward to 2021.
Our efforts are focused on identifying and owning companies that can thrive in the current investment landscape. The strength and momentum of US high growth, high free cash flow companies has been impressive. Further, the gap in returns to growth stocks over value stocks supports our work going back years. We are also seeing strong market interest in ESG-type stocks which includes certain utilities, and stocks of companies in pursuit of global environmental sustainability. We are pleased to see this evolution of the application of technology finally beginning to take hold.
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Bruce Hotaling, CFA
The views and opinions stated herein are those of Bruce Hotaling, are as of this date, and are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Investments are subject to market risk, including the possibility of loss of principal. Past performance does not guarantee future results. The S&P 500 is an unmanaged index of 500 widely held stocks. Investors cannot invest directly in an index. The PE ratio (price/earnings) is a common measure of relative stock valuation. This note contains forward-looking statements, predictions and forecasts (“forward-looking statements”) concerning our beliefs and opinions in respect of the future. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements.