March 16th, 2020

The Intelligent Investor's Market Memo

Financial Markets Crashed and Entered a Bear Market Due to Recession Fears Caused by the Coronavirus and the Saudi Oil Price War.

Recessionary fears due to the coronavirus pandemic and Saudi Arabia's oil price war coupled with a structural lack of dollar liquidity led to a financial market crash that ended the eleven-year bull market ended this week. Price moves were exaggerated by a negative feedback loop created by illiquid financial markets and rising volatility.

On Thursday, the Fed announced that it would inject a massive $1.5 trillion into the short-term funding markets to increase market liquidity and calm panicked investors. The New York Fed stated, "These changes are being made to address highly unusual disruptions in Treasury financing markets associated with the coronavirus outbreak." Stocks rose sharply on the announcement and then essentially crashed -- the S&P 500 closed down 9.5%, which was its worst one-day decline since the 1987 crash.

After reaching an all-time high on February 19th, the S&P 500 has plunged by 26.9% in 16 trading days, which was the fastest 20% drop from an all-time high since 1929. The MSCI EAFE Index (international ex-US and Canada) closed below its October 2007 high, which means that investors in foreign stocks have not made money in nearly thirteen years (see chart below).


For the week, the S&P 500 and the tech-heavy Nasdaq 100 fell by 8.8% and 6.3%, respectively. The small-cap Russell 2000 plunged by 17.3%. The MSCI EAFE Index (international ex-US and Canada) and the MSCI Emerging Markets fell by 18.4% and 9.9%, respectively. The price of oil crashed by 23.7%, while copper dropped by 3.4%. After plunging to an all-time low of 0.40% on Monday, the 10-Year U.S Treasury yield spiked to close the week at 0.95%.

This week the safe havens also performed poorly. Illiquid markets,  deleveraging Risk Parity strategies, and margin calls led to a plunge the safe havens. The U.S. Treasury long-bond (TLT) fell by 7.7%, while gold dropped by 9.3% for the week. Over the past 12 months, the S&P 500 is down by 3.6%, while gold and the long bond (TLT) are up 16.4% and 29.2%, respectively. The safe havens outperformance is typical during bear markets.

All of the S&P's sectors were down sharply this week. The strongest sectors, on a relative basis, were Technology (down 5.3%), Healthcare (down 6.7%), and Communication Services (down 7.3%). The weakest sectors were Energy (down 24.3%), Utilities (down 14.1%), Consumer Discretionary (down 10.8%), and Financials (down 9.8%).

Instead of waiting until their policy meeting on Wednesday, the Fed, on Sunday evening, took another emergency action to stabilize the economy and calm the financial markets. The Fed cut short-term interest rates by 1.00% to zero and said it would launch QE5, which will print $700 billion to buy longer-term mortgage and U.S. Treasury bonds.

Despite the Fed's aggressive move,  the futures market opened "limit down" at 6 pm Sunday, and the S&P 500 closed Monday's trading down 12%. This was the Fed's third attempt to "shock and awe" the market, and each time investors used the Fed's surprise action as an opportunity to sell aggressively. The Fed continues to use its financial crisis playbook to fight a health epidemic, and it appears that investors share our concern that the Fed was "pushing on a string," and is now out of bullets.

As our lifestyles dramatically change and the economy temporarily shutters, it is critical that both political parties come together to pass fiscal policies that address our nation's health concerns and the needs of the workers and businesses in the sectors of the economy that have been effectively shut-down.

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Our View:

     In the short-term (three-months): despite Friday's epic rally of 9.35%, stocks are in a panic, and volatility is near record levels. While the market is extremely oversold, and investors are fearful, we believe it is too early to buy. We will patiently wait for improving market breadth and a positive divergence by the bond market before increasing our short-term risk exposure. Our Tactical Asset Allocation turned negative when the S&P 500 broke below its January 31st low (SPX 3215).

      In the long-term (more than four years): stocks are in a bear market, and we continue to believe that the equity market offers a poor long-term risk-reward. Central bank liquidity and not economic fundamentals drove shares far from their intrinsic value. The global economy was vulnerable before the Coronavirus, and now we believe that a worldwide recession is inevitable. Because the Fed did not "normalize" interest rates during the economic expansion, they have fewer tools this time to fight an economic contraction. Also, since corporate debt levels are an all-time high, we are concerned that if we enter a profit recession, many corporations will have difficulty meeting their obligations. Our Strategic Asset Allocation is underweight equities relative to our benchmark.

Market Outlook

As we discussed last week,  the S&P 500 rallied by 18.8% from its October low to its February 19th high on the belief that the Fed's aggressive monetary actions (printing money to buy $60 billion of U.S. Treasury bills each month) and the signing of the "phase-one" trade deal with China would lead to an acceleration in economic growth.  The Fed's massive liquidity injection led to a very overbought stock market and complacent investors when news of the Coronavirus first impacted the markets in January.

While the resilient stock market reached an all-time high despite the uncertainty over the virus, the bond and commodity market signaled that the economy was at risk. Bond yields plunged, the price of oil and copper crashed, and the yield curve inverted while the S&P 500 continued its record run.

Our short-term market outlook was reduced to negative on February 25th, when the S&P 500 broke below its January low. We believed that the yield curve and the drop in bond yields and commodity prices indicated an increased probability of a bear market and a recession. We thought that prudent investors should use any Fed-induced rally to reduce their risk exposure.

The eleven-year bull market ended this week after stocks dropped by 26% in 16 days, which is the fastest decline since 1929. In addition to the economic uncertainty caused by the Coronavirus and the Saudi oil price war with Russia, there are significant market structure issues that have dramatically increased market volatility. 

These structural issues first appeared in the repo market this fall when there was a lack of dollar liquidity in the overnight lending market. The Fed had difficulty explaining the liquidity shortage, so they decided to print $60 billion each month to buy U.S. Treasury bills. The Fed's attempt to paper over the liquidity problem led the stock market to explode higher by 18.8% from October low to its February 19th high. Once the coronavirus shock hit the financial markets, the liquidity shortage spread to the U.S. Treasury market, which is supposed to be the most liquid market in the world.

On Thursday, to address the dollar liquidity shortage, the Fed announced that it would provide $1.5 trillion to the short-term funding markets. Then, on Sunday, the Fed cut interest rates to zero and promised to buy $700 billion of longer-term mortgage and treasury bonds to assuage the markets. Unfortunately, the Fed's aggressive move panicked investors, and the stock market fell an additional 12% today.

We believe the Fed's imprudent policy of financial repression (negative real rates and printing money to buy bonds) led to an unprecedented debt accumulation by corporations and financial institutions over the past decade.  The Coronavirus was the catalyst that forced institutions to attempt to deleverage at the same time. Since there were few buyers, market volatility increased, which led to a negative feedback loop between rising volatility and declining liquidity.  If the financial markets were truly free and not manipulated by the central banks, speculation and leverage (corporate and financial) would not have reached today's extreme level, and the financial markets could have absorbed the coronavirus shock much better. 

Given the shape of the yield curve, the bear market in stocks, and the sharp drop in commodities and bond yields, we believe the odds are high that a recession will occur in 2020. Since the typical bear market is a drop of 32% over ten months, we may be through the bulk of the decline already.

While the strength of the consumer and the robust labor market should lead to a mild economic contraction, we are concerned that the enormous corporate debt burden could turn a mild recession into a financial crisis. Since the last recession, the Fed kept interest rates artificially low to inflate the stock market and encourage lending. In fact, interest rates were below inflation for most of the past ten years (see chart below).


Corporations took the bait and borrowed to buy back their stock and acquire other companies. This financial engineering -- buying instead of investing and building – led to a record corporate debt burden (see chart below). Historically, excessive corporate debt levels to GDP have led to recessions.

Currently, 50% of investment-grade bonds are rated BBB, which is one level above junk. We are concerned that as the coronavirus slows the economy, debt downgrades and defaults will lead to additional economic pressure. Currently, corporate bond spreads are elevated, but significantly below the level that would indicate a potential financial crisis (see chart below).

Source: FRED

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Stocks Are Still Expensive, and an Earnings Recession is Inevitable

On February 19th, the S&P 500 closed at 3393.5, which was an all-time high. Since analysts forecast the S&P 500 to earn $177 in 2020, the market sold at a P/E of 19.2, which was the highest P/E since May 2002. Additionally, a P/E of 19.2 was 32% above its 15-year average P/E of 14.5 times earnings.

Given the coronavirus pandemic and the bear market in stocks, analysts' profit expectations appear unrealistic. According to Factset, analysts expect earnings to grow by 5.1%, down from 9.2% on December 31st.  While it is difficult to have a credible earnings estimate at this time due to the uncertainty due to the Coronavirus and the oil price war, we can value stocks based on last year's earnings.

According to S&P Global, GAAP earnings for the S&P 500 were $139.7 last year. If stocks sold at their average historical P/E of 15.8, the S&P 500 would fall to 2207, which would be a 35% bear market.  If Shiller's CAPE ratio, which attempts to smooth out the business cycle, returned to its historical average, stocks would decline to 1740, which would be a 49% bear market decline.

Source: Robert Shiller

In this uncertain and unprecedented environment, we believe that investors should focus on preserving capital and playing defense. The lack of liquidity and high volatility creates sharp rallies, which provide an opportunity for investors to reduce some risk exposure until the virus is contained, the economic damage is known, and stocks have a favorable risk-reward. Bear markets create great opportunities for prepared investors.

About the Author

J. Lawrence Manley, Jr., CFA has always had a passion for investing and has been lucky enough to spend nearly 25 years managing investment portfolios for pension funds, endowments and high-net-worth families. In his experience, there are two major obstacles preventing individuals from reaching their investment goals: Wall Street and Human Nature. Manley Capital was founded to overcome these obstacles and partner with clients to achieve their financial goals.