Taking Stock of the Situation

Stocks have fallen about 14% from their all-time highs reached just six business days ago. That is a remarkably fast and hard fall not experienced since the 2008 financial crisis. It is safe to say this week has been a full fledged panic*. Markets are trading on hypothetical “what ifs” rather than “what is” or “what is most likely”. So let’s talk about “what is” and “what is likely”.

Starting with a factual assessment of the stock market carnage, stocks have fallen back to levels of mid-2019 before the euphoric run-up into this year. Take a look at the chart below. I have been saying for some time that stocks are expensive (see accompanying article) and that these valuations are unlikely to hold. Indeed, the current level is within a hair of the level first reached in January 2018, over two years ago. Aside from the past 6 months, which we might consider a mirage, no real harm is done.

In the coming days you will hear a sizable amount of conflicting information regarding stocks, interest rates, and the health of the economy. Let’s be clear: after last year’s weakness, the economic growth firmed up going into winter. Consequently, nearly all economic statistics just released or about to be released will show this relative strength because such data is backward looking and does not yet reflect any of the virus’ effects. Important officials will reaffirm their belief that “the fundamentals are strong” as happens every time a crisis unfolds. In the coming weeks, data will start to reflect the virus induced slowdown and give us a better idea of its actual impact. This leaves a period of time where markets are left guessing as to whether or not this has been an over-reaction. Expect some rebound, then a selloff, and repeat. Large market swings will be as if spring loaded.

What is likely

Clearly the virus is already having some economic impact. Conferences, cruises, sporting events and a myriad of travel plans have been cancelled. The impact to tourism will be felt first and foremost, with ripple effects just beginning. Oil prices have fallen dramatically on anticipation of lower transportation demand.

The energy patch’s fracking revolution has been a relatively new development for the U.S. economy. In decades past, large energy imports left America vulnerable to rising oil prices. Since fracking began, the country has become nearly energy independent while creating a large number of high paying jobs. As oil prices tumble, this puts pressure on energy jobs and leaves less financially stable oil companies at risk.

And so it goes. Industrial companies including auto manufacturers are having difficulty receiving parts sourced in China, which slows production. Judging by the empty shelves of Purell in the grocery stores I’ve seen in the past few days, consumers are becoming increasingly wary. If consumers slow their spending, companies will look to cut costs, including labor. In essence, this is how a recession unfolds. Whether this happens and to what extent, we do not know.

It won’t be long before the Fed cuts rates again. Whether this has any positive effect is unclear. Already low rates have plummeted even further this week, but lower rates can’t help sick or quarantined workers get back to work. A “supply shock” is when an economy is disrupted by a sudden shortage. The best example is the oil embargo of the early 1970s which pushed the US into recession. Whether certain shortages of imported goods materially impact the U.S. economy is unknown and not on the same scale of importance as energy imports. The problem remains: widespread illness controls will impact both production and demand causing a recession.

The $64 trillion question is whether it actually comes to this? Will the virus become that widespread and disruptive? Your guess is as good as mine, but at this very moment, the biggest impact is from fear. It is very possible that all this just fades away in the coming weeks with the realization that the virus is not as widespread as feared. We would have then witnessed another of the many typical stock market corrections that happen every few years.

At a high level, I view this past week as the disappearance of a short-lived bubble where a euphoria and excessive optimism about future economic growth has disappeared. At some point, the valuation of stocks will better reflect an appropriate amount of risk and become attractive. That valuation and that particular amount of risk are to be determined as the facts unfold