Dow Plunges 1,000 Points on Virus Fears
“Dow Plunges 1,000 Points on Virus Fears” say the headlines. Curiously, these headlines completely ignore the fact that the virus has been a well-known phenomenon for the last 5-6 weeks. Judging from the zombie films I’ve seen, the corona virus is hardly the end of the world. Why is the stock market suddenly“plunging”?
The short answer is that sometimes markets lull themselves into a virtuous (or vicious) cycle of groupthink. Over these past five months or so, markets have ignored any reason to worry. After last year’s recession fear started to ebb, markets re-affirmed their belief that there is no alternative to owning stocks. The premise is that the Fed is going to print (more) money forever and money printing is always good, so buy stocks. This is the simplified version of the narrative, of course. I am a frequent viewer of CNBC (as you might guess) where one can watch a large cross section of supposed experts opine. The opinions these last few months can best be described by that famous scene from Leslie Neilson’s Naked Gunmovie franchise where the detective stands in front of a disaster area he caused saying “please move along, there’s nothing to see here” as onlookers gather.
That’s a bit of an exaggeration, but not much. Most of the experts thought last year’s slowdown and the accompanying recession warnings were transient. Fed easing/printing would re-lube the gears of commerce and we could look forward to accelerating economic growth. 2019 turned out to deliver below average 2% growth in the economy and about the same in profit growth. In the face of lower rates, stocks soared as investors started to discount the hope of future profit growth. “Please ignore the warnings, nothing to see here, buy stocks anyway.”
Our defensive outlook did not rely on a virus outbreak, which really was something out of the blue. Our defensiveness (which seems unnecessarily bearish when stocks go up anyway), is simply based on the idea that when investments are priced as if nothing can go wrong, something eventually will go wrong. Perhaps we should credit Murphy’s Law, but his principle ignores groupthink. Murphy was an engineer dealing with the design, implementation and use of technology. We are instead observing that human investors will over-react, this time by pushing stocks higher than the fundamentals warrant- which is precisely what makes them vulnerable. As everyone knows, it takes only the smallest contact with a bubble to pop it. Eventually some good reason to sell will cause a bit of panic.
Then the virus started to impact the real world in several ways. Apart from the human toll of sickness and quarantines, supply chains and travel have been affected. For example, Apple can’t produce enough ear buds, industry conferences are being cancelled worldwide, and relatively unaffected places are seeing tourist cancellations (France reported a 30% drop in bookings). Those supposed experts on CNBC had shrugged off effects of the virus as being a “one-quarter impact” with everything likely to rebound shortly thereafter. But will it rebound so fast? No one knows and therein lies the problem. If stocks were betting on a hoped for acceleration of growth but it increasingly looks as though growth may turn to stagnation, then stock prices are far too high.
Consider the “one-quarter effect” argument which goes like this: Yes, China shut down for the winter but all that lost economic activity will be recouped in future quarters after the virus passes. People will still buy the Apple earbuds when they finally arrive, so not much harm done. This hopeful argument belies the uncertainty in such a prediction. Sure, we’ll buy our earbuds this spring but will the Chinese that skipped going to restaurants, movies, concerts, sporting events, etc. suddenly double up on their outings? Will they buy two Starbucks once the quarantines and fears subside? People who cancelled cruises and travel aren’t likely to book two trips later this year either. Such economic activity is likely lost for good and will weigh on global GDP this year.
More concerning is whether the U.S. (and global) economy can weather such an unexpected blow? Recall that signs of pending recession were prevalent last year. Slow growth doesn’t leave much room to absorb shocks. Will this be the event that tips us from slow growth into recession? It is these realizations that stocks are finally confronting.
Where does this leave us? To begin, stocks are only 5% off the all-time high in the S&P500 and about flat on the year so far. That’s just a normal, garden variety pullback. The real question is what next? We don’t know, naturally. I suspect the virus’ effects start to wane, especially as the weather begins to warm. Stocks remain too expensive for the low-growth environment we’ve been in and certainly too expensive for any recession or near recession. Thus, expect more weakness but in a volatile up/down way as is typical of uncertain environments.