As you are probably aware, stocks have recently retreated as investors are trying to determine the economic and financial implications of the Coronavirus, or COVID-19. Despite beginning the year on a strong note, the Standard & Poor’s 500 (S&P 500) has now pulled back about 10% on a year-to-date basis. Many markets, sectors and industries are now in correction territory, meaning they have incurred losses of more than 10% from their 52-week highs. Interestingly, the S&P 500 was at a record high, just six sessions ago. We believe the sharpness of this selloff is more attributable to emotional selling and algorithmic trading than actual fundamentals.
For a historical reference, this marks the 27th stock market correction since World War II, with an average decline of 13.7% and recoveries taking an average of four months. Bear markets, where markets fall by 20% or more have occurred 12 times since WWII, with an average duration of 14 months. As a reference point for how stock prices have responded (and recovered) from other health scares, please see the charts at the end of this commentary.
As of today, globally there have been 83,788 confirmed cases of the virus and 2,869 deaths as a result of it. It is worth noting that most of the deaths have occurred in China, where the quality of healthcare may not be considered on par with that of Western nations. While these numbers are alarming, we would note that according to the Centers for Disease Control, through the week ending February 15th, 29 million people have contracted Influenza (commonly known as “the flu”), with 280,000 requiring hospitalization and 16,000 deaths.
We do not claim to be virologists and hence we will not try to predict the ultimate severity of this illness; however, history suggests that medical scares such as SARS, Ebola, etc. tend to have sharp, but shortlasting impacts on economies. China was the world’s sixth-largest economy when SARS was making headlines. Today, it is the world’s second largest. With many global companies sourcing materials through China, we believe COVID-19 will cause greater financial disruption than SARS, and thus we will experience slower than expected global GDP.
Over the longer-term, this may force some companies to question their reliance on China and resultantly look for other countries to source needed raw materials. Ultimately, this may lead to higher inflation, as China is a lower-cost producer than many other countries, albeit no longer the lowest.
Earlier this week, some Wall Street economists forecasted that COVID-19 would wipe out earnings growth for the S&P 500 for this year. Keep in mind that earnings for the S&P 500 dipped a bit in 2019, meaning that corporate earnings have flatlined for the past two years. Anemic earnings might be acceptable if valuation levels were lower; however, as shown in the chart above, price-to-sales and enterprise valueto-EBITDA valuations for the S&P 500 at the beginning of the month were on par with 1999 peaks.
As a result, some of the blue-chip tech names that have paced market advances for the past few years may not represent the safe havens they have in the past, especially where valuation levels are stretched. This reminds us a bit of the late 1990’s during the dot-com bubble, when investors did not consider valuations, rather they bought into stories. Clicks and eyeball views replaced traditional valuation metrics. When the bubble finally broke, 30% of the most expensive of U.S. stocks fell 32% from April 2000 to September 2002, while the cheapest 30% of U.S. stocks declined a modest 10%.
No one knows the future severity of the COVID-19 virus regarding its mortality and economic damage, not even the “experts”, and the virus has yet to be declared an official “global pandemic”. What we do believe is that at the moment, the level of panic exceeds that of the level of factual data. As such, investors should be reminded that decisions driven by panic are usually the wrong ones over the long-term. It is important to have a diversified portfolio that matches your risk profile. Additionally, it is important to know what you own and why. During times of panic, there will be disconnects between a company’s underlying fundamentals and its share price.
As you would expect, we believe it makes sense to avoid stocks with the loftiest valuations, as they will likely be the most prone to the largest pullbacks should conditions deteriorate further. Rather, we feel comfortable owning stocks with modest valuations and solid dividend yields. Specifically, we will continue to focus on names that do not rely on a strong economy to perform well, such as Consumer Staples, particularly in emerging markets where valuations are more compelling than those in developed markets.
To summarize, we believe it is best and most prudent to ride out some near-term volatility rather than give in to the panic by selling stocks and accordingly we may seek opportunities to deploy some of the cash holdings when more facts are known and when risk/reward ratios appear attractive.