March 2nd, 2020
Top Investment Trends Affecting Your Portfolio This Week
Global Pandemic Fears Led to a Panic in the Financial Markets This Week
Stocks had their worst week since the 2008 Financial Crisis, as investors reacted to the unexpected spread of the coronavirus throughout the globe. Fear that the virus’s spread would lead to a global recession led to an 11.5% plunge in the S&P 500 this week, while the10-Year U.S Treasury bond dropped by 0.34% to an all-time low yield of 1.12%. The decline this week erased nearly $3 trillion of market value from American companies.
In an attempt to calm the markets, Fed Chairman Powell released a statement on Friday afternoon, which indicated that the Fed was ready to act by providing more monetary accommodation. He said that “the coronavirus poses evolving risks to economic activity,” and “the Federal Reserve is closely monitoring developments and their implications for the economic outlook. We will use our tools and act as appropriate to support the economy.” Powell’s statement stabilized the market and a rumor of a coordinated central bank intervention this weekend led to a sharp 2.50% market rally in the last 15 minutes of trading.
For the week, the S&P 500 plunged by 11.5%, while the tech-heavy Nasdaq 100 and the small-cap Russell 2000 dropped by 10.4% and 12.4%, respectively. The MSCI EAFE Index (international ex-US and Canada) and the MSCI Emerging Markets fell by 6.7%, and 6.4%, respectively. In the panic, the economically sensitive commodities performed poorly – oil crashed by 16.2%, and copper fell by 2.6%.
This week the safe havens were mixed. The U.S. Treasury long-bond (TLT) rose by 4.9%, while gold plunged by nearly 5% for the week. On Friday, gold fell by 4.6% and had its worst day since June of 2013. Before Friday, gold had performed well during the market decline -- unfortunately, during market panics, investors are sometimes forced to sell what they can to reduce their exposure and meet margin calls.
Additionally, the yield curve continued to flatten this week, which indicates slower economic growth. The 3-month to 10-year U.S. Treasury yield curve dropped by 3bps and closed the week at -0.14%. The yield curve is an excellent indicator of future economic growth and inflation. Typically, when the yield curve remains inverted for a month, it becomes likely that a recession will occur in the next eighteen months.
All of the S&P’s sectors were negative this week, and interestingly, the defensive sectors performed as poorly as the economically sensitive sectors. The worst sectors this week were Energy (down 16.4%), Financials (down 13.6%), and Industrials (down 12.6%).
As we discussed in our last market memo, 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 made a record run.
Our short-term market outlook was neutral because the market was extremely overbought, breadth was weak, investors were complacent, and there was a significant divergence between the stock market and the bond and commodity markets. On February 25th, the S&P 500 broke below its January low, and we reduced our short-term outlook to negative.
Stocks appeared to stabilize late Friday afternoon on the belief that there would be a global coordinated effort by the central banks to provide liquidity and stabilize the market. According to Fed funds futures, there is a 100% probability that the Fed cuts interest rates by 0.25% by its March 18th meeting, and there is a 74% chance that they decreased interest rates by 0.50% by there April 29th meeting.
We expect the Fed will act, which will fuel a short-term rally (see the chart of the day). We believe that the odds of a global recession and a bear market have increased dramatically, and prudent investors should use any Fed-induced rally to reduce their risk exposure.
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Despite the Decline Stocks are Expensive and the Fundamentals are Uncertain
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 is 32% above its 15-year average P/E of 14.5 times earnings.
While stocks are very expensive, we are concerned that the current earnings estimate is unrealistic. Analysts continue to believe that profits will grow by 7.0% on revenue growth of 5.2% in 2020. Last week, Apple, Microsoft, UAL, and Mastercard announced that they would not meet analyst’s Q1 forecast because of the coronavirus impact on the economy.
Goldman Sachs reduced its 2020 earnings forecast from 7% to 0% growth, which means the S&P 500 sells at a P/E of 17.9 times and is 23.5% above its 15-year average P/E. Goldman also stated that if the coronavirus leads to a recession, they believe that earnings will fall by 13%
We believe that the probability of a bear market has increased dramatically. Stocks had their sharpest decline on record, the yield curve is inverted again, and the commodity markets have crashed. The S&P 500 has declined by 15.8% from its February 19th peak to its trough on Friday – the typical bear market is a 32% decline.
We believe that earnings will be flat to down this year, and we expect that valuations will regress to an average level, given the economic uncertainty. If profits are flat this year (as Goldman forecasts) and the P/E returns to its 15-year average, the S&P 500 would decline by 29.5% to 2392.5.
To deal with uncertainty, investors need a philosophy and a strategy. Our simple philosophy is – focus on preserving capital. We expect the central banks will act and do whatever it takes to stabilizes the financial markets. While lower rates will temporarily drive the market higher, it will have little economic impact, and the Fed will be “pushing on a string.” We believe that prudent investors should use any Fed-induced rally to reduce their risk exposure and play defense until the virus is contained, the economic damage is known, and stocks have a favorable risk-reward.
Chart of Week: When the Fed Intervenes, How Far Will the Market Rally?
On Friday, stocks rallied by 2.5% in the last 15 minutes of trading because of a rumor that the Fed was orchestrating a global intervention to stabilize the financial markets. Based on previous market panics, stocks typically retrace 38% to 62% of their decline, so a rally between 7% and 11.6% is possible when the Fed intervenes. We believe that any Fed-induced rally offers investors an excellent opportunity to reduce their risk exposure, given the uncertainty over the virus and its impact on the global economy. In our view, the probability of a recession and bear market are high, and it is prudent for investors to reduce their risk exposure during any Fed-induced rally.
Is Your Retirement On Track?
In the short-term (three-months): stocks offer a poor risk-reward, and our outlook is negative. The stock market is in a short-term panic, and investors are anxiously awaiting the central bank intervention. We will use any Fed-induced rally too reduce our cyclical holdings and increase defensive positions. While the market is oversold, and investor sentiment is fearful, we will patiently wait for improving market breadth and a positive divergence by the bond market before adding to our 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): despite the sharp decline, we continue to believe that the stock market offers a poor risk-reward. Central bank liquidity and not economic fundamentals drove stocks far from their intrinsic value. The global economy was vulnerable before the coronavirus, and now we believe the odds of a worldwide recession have increased dramatically. 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.