Last Week, the Market Delivered All-at-Once the Anticipated Correction

by Hubert Marleau, Market Economist, Palos Management

March 1, 2020 – This was the week that Coronavirus defeated the market hands down. In the seven business days ending on February 28, the S&P 500 lost 12.8% of its value--the fastest correction on record. The fear of Covid-19 was more viral than the flu. Quant traders love to trade good and bad events, particularly when they are a function of an exogenous uncertainty that remains unresolved or an opportunity that seems limitless. The global contagion of fear became more fearsome than the virus as governments reacted with extreme measures and the press hyped the threat further.

While the headlines are disrupting global economic activity and raising the risk of contracting it, they are also promoting public awareness, political interventions and social responses that should eventually help to contain the virus. Unfortunately, the world was not ready to deal with a global outbreak. Its health officials are playing catch-up as governments have invested little in disease prevention and disease preparedness.

Yet, a growing number of reports suggest that certain things are being done. The speed and expansion of testing is improving just about everywhere. Is it enough to do the trick? What is needed is news of a novel vaccine or an effective treatment, otherwise the hope that the disease could be under control in the future is questionable.

Professional opinion is that it will take a year or more to develop and test a vaccine. The potentially quicker solution is the development of a drug for the treatment. In this respect, the antiviral drug Remdesivir, which has been designed to treat Ebola, but which has been shown to be active against a broad spectrum of viruses in vitro and in animals, is currently being evaluated in China, the U.S. and elsewhere. Commencing these trials so quickly has only been possible because the safety of the product has already been established through the Ebola studies.

It will be quite fortuitous if it is effective against the coronavirus, but it will be some time before we know. That said concerns about what the final impact of the coronavirus crisis will be on the global economy are legitimate. Initially, it will be deflationary because purchases of many non-essential goods and services will be either postponed or shelved. Secondly, inflationary pressures will emerge when rising pent up demand will be faced by a disrupted supply chain.

This throws a monkey wrench in “just in time” production. Many business executives have reported that they are seeking alternative supply chain solutions and secondary outsourcers to supplement existing manufacturing outlets. The uniqueness of this demand and supply shock has provoked a reassessment of what are the economic risks. It has also brought about a long overdue repricing of financial assets and an appropriate rebalancing of values.

In seven days, stock market valuation metrics have materially changed. The Equity Risk Premium (ERP) rose from 3.50% to 4.78% as both P/E multiples and bond yields fell about 1.78% above what is considered normal. The Rule of 20 which is the addition of the Forward P/E multiple to the expected rate of inflation is presently 18.2 below the 20.0 bearish threshold. Moreover, the S&P 500 dividend rate is 2.08%— 92 bps above the ten-year U.S. treasury yield (1.16%).

While a good chunk of the redressing is attributable to the knee-jerk actions of traders who seek survival over returns, the weighting out of passive equity funds into cash and the lack of dip buyers had a large shoal effect. It should be noted that the aforementioned calculations were done after taking $6 off the aggregate 2020 S&P 500 earnings per share for 2020. The new estimate is $174.00 per share.

In periods like this one, it becomes important to exercise scrutiny and do a lot of number crunching to get a sense of what the commodity and bond markets are signaling. In the past seven days, yield on ten-year U.S. Treasuries decreased 35 bps to reach a low of 1.16%, 34 bps less than the low range of the current policy rate but 23 bps higher than the yield for 2-year notes (0.93%).

Moreover, the neutral rate (0.95%%) is 55 bps lower than the Fed’s policy rate. Unlike oil, highly sensitive copper and lumber prices are down but they have been able to hold their critical support zone—an encouraging observation. Encouraging because there were no major price movements in either gold or the DXY. On the contrary, they are both down a tiny bit.

What does it mean? The bond, forex and commodity markets are betting hard that central banks will introduce a rate cut very soon and maybe even before the next schedule FOMC meeting if the officials feel sure that it wouldn’t spook investors. Moreover, governments will likely pre-empt the central banks by announcing targeted measures. Perhaps surprisingly, it means that a natural recession is not in the offing.

The belly of the yield curve is not inverted while copper and gold prices are in a holding pattern. Why is that? Expectations are very high that all of the major policy makers will engineer a worldwide coordinated “whatever it takes” solution to arrest and reverse recession fears. Indeed, the monetary and fiscal authorities learn from the wisdom of the crowd. And, the crowd is insisting on a rescue plan.

In my judgement, the central banks have no other choice but to succumb to the wishes of the market. It boils down to the fact that we have a huge balance sheet economy with financial assets having outgrown the economy by a large margin. Consequently, volatility in asset prices has an enormous effect on the real economy. The job of the Fed is to ensure economic stability. Thus, the response to asset price weakness is rate cuts or other forms of monetary stimulus. The bull steepening bias of the bond market is telling us that the monetary authorities will imminently exercise the “Fed Put”.

I realize that the problem is biological, but the outcome will bring unintended economic instabilities and imbalances--and the job of the Fed is to fix them. Additionally, the authorities have an excellent excuse to ram through another rate cut because their preferred inflation gauge—the Core PCE deflator—was still running well below their 2.0% target at 1.6% y/y in January.

In the fullness of time, history suggests that a beaten down stock market usually gets back on its feet to fight another day. And it normally starts to do so when certain reliable trading metrics are positively aligned. There will be a moment when out of the woodwork, traders will decide that they have discounted enough bad news and stop reacting to every bad headline.

Undoubtedly participants will search for signs of a bottom. I noticed that my three favorite market ratios which many speculators rely on to trade out of short positions, were trending up. These are the ERP/ Fear & Greed Index, Vix Index/ten-year bond yield, Vix Index/10-year minus 2-year bond yields. Put simply, speculators are probably starting to think about monetizing their downside equity hedges and upside volatility plays. The speed and depth of the correction will force the Fed to heed the supremacy of the markets.

Powell admitted that he was willing to “bend the knee”. Interestingly, the copper/gold ratio, the best predictor of long-term bond yields bar none, has slowly but constantly upticked all week suggesting that long term bond yields are out of whack with reality and should at least stabilize and possibly rise, even though the chance of an imminent rate cut is 100% and that three of them are in the cards for 2020. That’s a call for an eventual bull steepening yield curve.

Unfortunately, we have a Covid-19 running around surreptitiously infecting people that can kill them, particularly if they are old and impaired, without a proper treatment or vaccine. Although valuation metrics are back to where they were a year ago and the prospect for easier money and stimulating fiscal measures are

certain, it may take a while before we get a sustainable rally. Over time, the markets will rationalize what’s going on and acknowledge that business can be done with sensible precautions. Yes, China’s February PMIs were awful. One could not have expected anything else, given the shut-ins, quarantines, travel restrictions and lockdowns. That was February.

The GaveKal Researchers, acknowledged experts on China, reported in Barrons that economic activity is now reviving—-“traffic congestion, property-sales and coal-use metrics are bouncing back as China reopens.” The Barron wrote that “China is back online.” Meanwhile, economists at Cornerstone Macroeconomics commission a daily measure of consumer confidence finds that U.S. consumers sentiment remains elevated. The five-day average as of February 27 was 158, close to the gauge’s all-time high.

The question is not whether the market will eventually recover. It's about how and when. An explosive moonshot could potentially occur, but it would be choppy. Why, I’m afraid that it could be viewed as a bounce to offload shares. In this respect, we added some portfolio protection to our portfolios so that we could prudently stay invested. We carefully reduced several recessionary sensitive positions except energy stocks. I expect an OPEC reaction while China is strategically building reserves. Additionally, we have judiciously increased our exposure to utilities, telcos and reits.

Canadian names in those three sectors are yielding, on average, 400 bps more than Canadian government bonds. They handsomely pay while one waits. We decided to stay in and prudently ride the waves. There is too much empirical evidence that after a steep correction, stock prices end up higher within a year. Why? People sell first and ask questions later—-96% of the entire S&P 500 is in correction territory. Fred Imbert, a CNBC reporter wrote: “Since WWII, the S&P 500 has had 26 market corrections. During those corrective periods, the S&P 500 has declined by an average of 13.7% and has taken about four months to recover.” Only two corrections turned into bear markets.

The Historical Stock Market Facts:

There are many who argue that stock markets are untethered from fundamentals and that it is no more than a giant casino. The argument is based on the notion that the stock market is directly rigged by stock buy-backs, high-frequency trades and false reports, in addition to indirect manipulation by passive funds, the policy of central banks and government intervention. In other words, they believe that because markets are not free, making it impossible for anyone to trade for gains or invest for profits.

Manipulations and interventions have been around since the inception of stock exchanges. Stock jobbers, operating out of bucket shops were notorious for their intrusions. Market interventions and manipulations by personalities like Jay Gould and John Pierpont Morgan among others traded in ways that would be considered illegal today, but they were instrumental in keeping markets orderly. Today, we have regulators, corporations, central banks and governments playing a similar role of calming things down but legally.

It is important to be aware that we are humanly frail. The fact is that the stock market is played by humans who are far more emotional than rational and a lot more fearful than greedy. Behavioral economics (Read: Thinking, Fast and Slow by Daniel Kahneman) clearly shows that people tend to refuse to take on huge profit opportunities even when the odds are excellent because their aversion to risk is irrationally high. The point is that the people have varying opinions, time horizons, personalities that tend to affect market sentiment at any given time.

Yet, the invisible hand of the market has a way of getting things right over the long haul. This is why it’s important to rely on data and resources independent of psychological complications and be rational about what the future may bring. The market is not a casino. Before I wrote this piece, I went to the Montreal casino to witness the degree to which the players are irrational and emotional. There were a few loud exaltations but only after long intervals while people were consistently losing money everywhere.

The market is not a casino. The opposite is true. The longer you stay at the casino, the smaller the probability of winning. The longer you stay in the market, the larger the probability of winning.

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