The Panic Begins

Panic selling began in the equity markets this week as the scope of the COVID-19 pandemic continued to grow.  When we pointed out the emergence of the virus as an economic risk back in January, hope remained that it could be contained.  Now, we face a global pandemic with sustained outbreaks in several US cities. 

Thursday’s 9.5% decline in the S&P 500 was the worst one-day decline since 1987.  One has to look to the Great Depression to find another day of similar magnitude.  The level of fear currently compares to the worst of the 2008-2009 Financial Crisis.  The year-to-date return of the S&P 500 currently stands at -23.2%, surpassing the arbitrary bear market threshold of -20%.  From the February 14th peak, the index declined by over 27%.  In the last two bear markets, the S&P 500 fell by approximately 50% peak to trough.  This did not happen all at once, rather it occurred over the course of several quarters.  One can get to approximately a 50% decline by three 20% declines.  Could this happen again? Maybe.

While social distancing protocols helped stem the COVID-19 in China, Japan and Korea, it has come with a severe cost. We expect the impact now sufficient to put the US and global economy into recession.  Equity valuations should be understood in this context. Many unknowns still remain, particularly how the virus will respond to warmer weather.  Other coronavirus outbreaks tend to dissipate in warm weather. Hopefully, this will be the case with this virus, but it remains uncertain.  Even if this does occur, will another outbreak occur next fall?  A vaccine remains at least a year away, so we should assume the summer of 2021 as a reasonable worst-case scenario for the end of the pandemic.

In light of the US economy currently being in a recession, a 20% decline in stocks from record valuations does not appear excessive.   There may be more downside before this ends. Over the last year, we have commented extensively about the record amount of corporate leverage, particularly in privately held companies. An extended contraction risks a proliferation of corporate bankruptcies and corresponding wipeouts of equity values.  Balance sheets remain the only way to survive these downturns.  Despite the rage for passive investing that likely will not survive this bear market, we believe the value in active management lies in avoiding companies at risk of bankruptcy.  All of our active managers prioritize strong balance sheets, and this strategy served clients well in the downturns of 2000-2002 and in 2008-2009.

The worst case scenario consists of a nasty recession that lasts until the threat of this virus ends, either through a vaccine in a year or so, or a successful containment ending the risk after a few months. However, attempting to trade around this volatility remains a mistake.  Markets anticipate events, selling off before recessions are officially declared and recovering before the data suggests the recovery has started.  For investors who sell their stocks, no all-clear signal will tell them it is OK to get back in.  Recoveries tend to happen as fast as downturns.  When this market does recover, I expect it may do so over a few weeks, with gains comparable to the declines of the past few weeks.  Successful market-timing requires two successful trades – selling before further downturns, and buying back in before the bulk of the recovery.  In 2008, a global depression appeared likely, but the market recovered.  Like the 2008-2009 Financial Crisis, this pandemic will pass and normal commercial and personal life will resume.  There is no need to worry about your portfolio, it will recover and we have been working with you to allocate adequate safe liquidity to last until it does.

–  Stephen C. Browne, CFA, CIO