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In just two days, the DJIA shed over 1,900 points, or 6.6%. In two days, the Dow gave up all of the gains registered since the latest upward thrust in stocks began in October. Peak-to-trough through Tuesday: -8.4% (over eight trading days).
A review of the broader-based S&P 500 Index tells a similar tale. A peak-to-trough sell-off of 7.6% (over four trading days), with the index trading at its early December level.
What happened? Over the weekend, investors were bombarded with headlines that the coronavirus was no longer contained to China. Given today’s rich valuations, algorithm-based trading programs hit the sell button.
Previously, investors had kept a cautious eye on China and the implications of falling Chinese demand and shuttered factories, which crimp supply chains. That’s still the case, but investors are now fretting over fears the virus is set to spread into the U.S., hampering growth at home or tipping the economy into a recession.
The 10-year Treasury yield hit an all-time low on Tuesday of 1.31% in intraday trading and the 30-year bond hit a series of new lows in recent days.
While epidemics have rarely had much more than a temporary impact, investors have few landmarks to base decisions on today amid fears the virus will hit the U.S. The fundamentals have been muddied by an apparent supply shock and possible demand shock, so fear and the technicals rule.
We know that heightened uncertainty creates a risk-off trade. Heightened uncertainty simply means the number of economic outcomes have widened, and that widening is all on the downside.
But is the outlook really that bad? Are we set to sink into a profit-killing recession that pummels stocks? Have short-term investors overreacted, distorting normally reliable indicators?
1. The impact from coronavirus
- Figure 1 shows that total cases have leveled off, as China appears to be getting the epidemic under control.
Figure 1: Total Cases (Logarithmic Scale)
Source: Worldometer (combines stats from global health organizations) 2/26/2020
- Figure 2 shows active cases (total cases less recoveries and deaths) have declined.
- As of February 26, there were total cases of 81,249 less recoveries of 30,347 and deaths 2,770.
Figure 2: Total Active Cases
Source: Worldometer (combines stats from global health organizations) 2/26/2020
2. The fear
- Fear has spooked investors—the virus is no longer contained to China and is poised to spread through Europe and the U.S., disrupting daily routines and economic activity.
- Adding to the dark mood are comments from the CDC indicating that we’ll likely see a pandemic and Americans should prepare for school closures or telecommuting.
3. The economy
- It may be several weeks before we see any possible significant impact on the data.
- The bond market has reacted.
- Unlike 2019, when falling global yields pulled on U.S. yields, the spread between Germany’s 10-year and the U.S. 10-year has narrowed, as U.S. yields have led to the downside.
- The 10-year/3-month has inverted again, but the 10-year/2-year has not, amid expectations of new Fed rate cuts.
- Figure 3 shows one key indicator that isn’t flashing red. The 30-year less the 10-year is steep and not signaling a recession.
Figure 3: 30-Year Treasury Yield Minus 10-Year Treasury Yield
Source: St. Louis Federal Reserve, NBER Shaded areas mark recessions 2/26/2020
- The Fed can help support demand with a rate cut but can do little if there is a supply shock. Still, fed funds futures are pricing in a 33% chance of a March rate cut and a 68% chance of a rate cut by the April meeting.
- Fed Vice Chair Richard Clarita said it’s “still too soon to even speculate” about how the virus will affect the U.S. economy.
- Cleveland Fed President Loretta Mester said a “wait-and-see” stance is best.
- The Fed isn’t ready to blink yet.
4. How to respond
We know market volatility is inevitable, but it can be unnerving when it occurs. Yet, downturns tend to be temporary. Investors in a well-diversified portfolio that lines up with their risk tolerance and time horizon shouldn’t be concerned. Bryce Sanders’ “How to Handhold Nervous Clients” provides an excellent outline for handling client inquiries.
Be proactive. Provide clients with an explanation behind the market’s slide, reiterate your firm’s opinion, remind them once again that declines are inevitable, and keep investors focused on the long-term financial plan.
Do your clients want to run to cash? Explain the trade-offs, i.e., a reduced risk means reduced longer-term return and how that will impact financial goals.
Remind them that the financial plan incorporates setbacks and inevitable market volatility.
They turn to you for leadership when times get scary. They expect you to manage their emotions and provide them with a steady hand when the waters become more tumultuous.
5. Final thoughts
Volatility likely isn’t over. What happens to stocks if/when we see outbreaks in the U.S.?
There are fears in some corners that the coronavirus could morph into something similar to the Spanish flu, which killed over 600,000 in the U.S. and may have infected up to a third of the world’s population. No one knows the ultimate trajectory of the coronavirus, but this is 2020, not 1918. The health care system is better prepared to deal with an epidemic.
When it comes to the flu, the CDC says there have been at least 29 million illnesses, at least 280,000 hospitalizations, and sadly, 16,000–41,000 deaths. And we go about our daily routines.