The current COVID-19 sell-off and situation is like nothing we’ve ever seen. The largest countries are only starting to respond with severe mobility restrictions, which will last for at least several weeks, and potentially several months. A global recession seems almost certain as people stay home and activity slows considerably, hurting many parts of the economy. Risk premium measures such as VIX are at extreme levels relative to history. Still, it’s impossible to predict where the market will bottom because of all the unknowns. It’s likely this bear market will last at least several months. Below are important themes to consider to navigate the market turbulence.
The most rapid decline in history
As is the case with any black swan event, few expected a global pandemic to bring about the end of the longest bull market in history. The rapid spread of the COVID-19 virus coupled with uncertainty about when the rate of new cases will finally slow is causing risk premiums to rise to levels rarely seen before. The VIX reached 79 last week, which is just slightly below the 89 level reached in October 2008.
VIX spiked to 77, almost matching the 2008 peak
Among all SPX declines greater than 20%, the current decline — 3 weeks since the high on February 19 — happened faster than any other. The speed and severity of the market decline reflect how serious the crisis is. Even if the current bear market resolves faster than the historical median of 64 weeks, investors should be prepared for prolonged volatility as the number of coronavirus cases increases over the next several weeks and the economic toll becomes more clear.
S&P 500 declines > 20% since 1930. The current decline is the most rapid
Looking at bear markets since 1929, the current drop of 27% is less than the median decline of 31%
US equities will likely bottom when the virus spread slows
It’s impossible to know if the SPX bottomed last week or when it will bottom. The two related issues the market will need clarity on is when the pace of new cases slow and how much the economy slows. President Trump’s shift from initially downplaying the coronavirus to mobilizing an aggressive response was an important step in the right direction. The House also passed a bipartisan bill on Friday to expand access to free testing, provide $1 billion in food aid and extend sick leave benefits to vulnerable Americans. Over the weekend, the Fed announced that it would cut rates by 100 bps and initiate a $700 billion QE program buying Treasuries and mortgage securities.
China provides a pertinent roadmap showing that the Chinese equities (FXI) troughed around the time when the rate of new cases started to decelerate. FXI had a local bottom and rallied at the end of January when the growth rate of new cases fell below 20% for several days, confirming that the spread of new infections was slowing. FXI has since made new lows due to the coronavirus spread to other countries and its impact on the global economy.
Chinese equities troughed after growth rate of new cases started to decline
In the US, tracking new cases to discern a market bottom is complicated by the fact that testing for COVID-19 has been limited. New cases will increase exponentially over the next 4 weeks as testing becomes widespread. Johns Hopkins Dr. Marty Makary said, “I think we have between 50,000 and half a million cases right now walking around in the United States.”
Italy may provide a leading indicator for the US. The growth of new cases in Italy is important to monitor because the US is following a similar trajectory and Italy started limiting social interaction about a week before the US.
The growth of new cases is similar in Italy and the US
Koyfin has two dashboards to track the number of coronavirus cases and deaths in each country as reported by the World Health Organization. After you open the dashboard from the links above, click “Follow” on the top right, and the dashboard will be stored in your MYD menu.
A recession in the US is unavoidable
The coronavirus will likely tip the US economy into a recession, with negative GDP growth in 1Q and 2Q. The impact on the economy has already started with cancelled events including virtually all college and professional sports, as well as Broadway shows in NY. Dining at restaurants in major cities like Boston, New York and Washington D.C. is down 60% relative to last month according to Opentable data.
Goldman Sachs strategist David Kostin lowered his S&P 500 earnings estimate last week and now expects -15% EPS growth in 2Q (vs. 4% consensus) and -12% growth in 3Q (vs. 7% consensus). Most Wall Street analysts have not lowered estimates while waiting for confirmation from companies that business is deteriorating. JP Morgan is a good example because the company is highly leveraged to the US economy and capital markets. JPM stock is down 25% while EPS estimate revisions are flat.
JP Morgan earnings estimates are flat despite a 25% stock decline
Equity themes to monitor
Beta has been a major driver of sector performance, which is unsurprising. Since the sell-off started on Feb 19, cyclical sectors, including Financials, Industrials, Materials and Energy, are underperforming. On the flip side, defensive names including Health Care, Staples, Utilities and Real Estate are outperforming.
Sector performance relative to the S&P 500 (SPY) since Feb 19
Within the cyclicals sectors outside of commodities, the biggest surprise is the outperformance of Tech and underperformance of retail. Tech (QQQ) was a leader coming into the sell-off, and has further outperformed because the sector has clean balance sheets and high cash flow, which are ideal for an environment where the economy slows and credit tightens.
On the other hand, the retail (XRT) underperformance trend before the sell-off has since accelerated. Retail over the past several years has been hurt by the shift from offline to online. That shift will further accelerate over the next several months as consumers stay home.
On a relative basis, Tech has continued to outperform, while Retail continued to underperform
During sell-offs, a good hunting ground for long candidates is stocks that outperform their expected beta. Using that filter, the largest tech stocks known as FAGMA (FB, AMZN, GOOGL, MSFT, AAPL) are attractive long candidates given their dominant market positioning, strong balance sheets and low reliance on physical consumer foot traffic. The rolling 1-month beta of FAGMA stocks declined as the sell-off started, suggesting that investors are rotating into these stocks.
Beta of major tech stocks has declined during the sell-off
Given the steep decline in interest rates, the Real Estate sector (XLRE) is a good long candidate. About two-thirds of the stocks in the XLRE ETF are traditional REITs operating in the real estate space, and one-third are REITs that own data centers and cell-phone towers. (You can see the full list of constituents using the holdings function in Koyfin.) The XLRE yields 3.3%, which is attractive relative to the 1% 10-year yield.
Real Estate sector looks attractive given the decline in Treasury yields
Stock prices in the energy sector have collapsed after Saudi Arabia indicated it would start a price war to gain oil market share. Energy has underperformed the S&P 500 by almost 50 percentage points over the past year. That underperformance has made Energy the 2nd smallest sector with a 2.7% weighting in the S&P 500, down from 15% in 2009.
Energy is the 2nd smallest sector in the S&P 500 with a 2.7% weighting
A handful of energy companies stand to benefit from the Saudi induced price war. Shipping and Tanker stocks including FRO, STNG, DSSI and EURN will benefit from higher volumes and pricing power as more oil is stored and transported. Another group in the energy sector that may benefit is US E&P companies such as EQT, COG and CNX that focus on natural gas and have little oil exposure. The Saudi price war is expected to stabilize natural gas prices due to decreased shale fracking activity, which has flooded the US market with supply.
Performance of oil tankers (blue) and natural gas production (green) stocks
It’s tempting to pick the bottom of the current sell-off given extreme risk measures like VIX. However the almost certain spike in coronavirus cases suggests that the current volatility, economic impact and secondary knock-on effects will persist for several quarters. This is one of the worst economic downturns that the US will endure and will last several months or more. But like other crises before it, this too shall pass.
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