March 02

COVID-19: The road ahead for markets

By David Nelson, CFA CMT

It took less than seven trading sessions for the S&P 500 to fall from an all-time high to a full-blown correction, now off 12.76% from the February 19th close. Fears that the coronavirus which first broke out in Wuhan an industrial city in the Hubei province of China has wreaked havoc on markets not to mention just about everyone’s 401k or retirement plan.

The correction

The pace of information flow in an internet connected world is matched only by algorithmic trading computers where milliseconds can mean the difference between profit and loss. In that context today’s markets discount data in light speed rather than ripping off the band aid slowly.

We had several attempts at an oversold bounce that were quickly sold setting us up for more pain and the fear that follows. This will not end as quickly as it started, and I expect several retests until we start to see a peak in the number of those infected and COVID-19 has run its course.

After a chaotic week it’s important to take a step back and do a deep dive into just what this means for the economy, earnings and of course markets.

There are any number of factors that drive market performance but in the end, stocks follow earnings and over the long run discount cash flow and or dividends. They don’t live in a vacuum and most security analysis starts with the risk-free rate which is fortunately quite low. I expect the Fed to cut at least 50 basis points by June and while it will provide liquidity and help shore up confidence it will have little effect.

Global Reach of COVID-19
Corona reach map

It’s safe to say my belief a couple of weeks ago that stocks were starting to look through to the other side of the crisis building in China was wrong. All that changed last weekend when we learned that cases of COVID-19 the coronavirus were showing up outside the country.

Markets reacted before analysts could get out their calculators and by mid-week the estimate revisions started to go negative. Estimates for the 1st and second quarter are now starting to fall. Last week we heard from two of the biggest Apple (AAPL) and Microsoft (MSFT) who both cut estimates as it became apparent that business was slowing. Of more importance is how long will supply chains remain disrupted and when will business travel return to norms. Already most companies have cancelled or halted non-essential travel for their employees.

Goldman’s latest estimate is one of the more draconian and maybe a good place to start. At $165 they are well under the current consensus of $174 which is likely too high.

Pandemics

Over the weekend I was speaking with a medical professional from Dartmouth University Hospital which is well equipped and trained on just how to deal with a pandemic outbreak. He pointed out the H1N1 influenza outbreak in 2009.

According to the CDC from April, 2009 – April, 2010 sixty-one million Americans were infected with the H1N1 virus, a true pandemic. The next 12 months saw 275,000 hospitalized and over 12,000 deaths. The professionals at Dartmouth tell me they are far more prepared then they were then. Putting it in context as of this writing there are currently 88,000 infected worldwide and over 3000 deaths. In the U.S. the latest numbers show 75 infections and as of this weekend our first death.

It’s true outside the United States where there are more cases the fatality rate is running between 2% and 3.4% but well below the 10%, we saw during the SARS outbreak. Lost in the fear and social media hysteria is the fact that to date over 45,000 have recovered.

All in COVID-19 while clearly a systemic event still in its early stages is at least here in this country looking more like 911, Katrina or a meteor hitting the earth. This is clearly a supply shock and not a demand driven slowdown.

Observations from Friday’s session

While still a negative day, it was the only session last week that closed at the high. On its own hardly a confidence builder but there were a few other bright spots as well. The semi-conductor index or (SMH) was up close to 2%. Qorvo (QRVO) one of the hardest hit with 75% of their top line exposed to China closed the day up over 6%. Likely a lot of short covering but perhaps some fundamental buyers stepping up to the plate.

The days and weeks ahead will be challenging and the temptation to overreact to every sliver of news both good and bad is high. Most of the focus this week will be on COVID-19 and how fast the infection is spreading.

At the start of every month we have a lot of economic data to digest and March is no different. We have the ISM Manufacturing data on Monday and of course on Friday a look at February non-farm payrolls. Two weeks from now we have an FOMC decision. A month ago, few saw any change in Fed policy in March. Today almost 100% are looking for a cut with 64% expecting a cut of 50 basis points. Again, soothing but mostly cosmetic.

*At the time of this post some funds run by the author were long AAPL, MSFT and QRVO