Episode description

Update on markets

The progression and measure of financial markets in response to the coronavirus outbreak has been reminiscent of the 2008 global financial crisis.  Now, let me be clear, we do not believe this is a repeat 2008. What we do believe, however, is the impact from Coronavirus will likely be large but the economy is on more solid footing and, importantly, the financial system is much more robust than it was leading up to the crisis of 2008.  I don’t want to sound overly optimistic, but in our opinion, we believe investors should be level-headed, remember that investing is a long-term strategy, and stay invested. 

Let’s face it, the future evolution and global spread of the coronavirus outbreak is highly uncertain. What we know is that containment and social distancing are ultimately achieved by reducing economic activity. Faced with resource constraints in healthcare systems, a number of strong incentives are in place to encourage aggressive containment of the virus. The impact on economic activity will likely be sharp – and the damage may be deeper than anticipated, but the outbreak will eventually dissipate. The BlackRock Investment Institute concluded that now is the time for a decisive, pre-emptive and coordinated policy response to avoid the disruptions to income streams and financial flows that could cause persistent economic damage – failure to act could end the current economic cycle.

The coronavirus, discovered in late 2019, had no impact on 4Q19 GDP, but we are confident in saying it certain to push GDP growth down in the first two quarters of 2020 and possibly the last two quarters. Here’s what we know about the virus as of today, March 11th.  There are 125,000 reported cases worldwide, 4,600 deaths and approximately 70,000 have recovered. Now, let’s compare severity of Corona to influenza.  In the U.S. alone, 16000 have died from the flu and approximately 280,000 are hospitalized.The mortality rate for the flu is significantly higher – perhaps American’s should be more concerned about flu shots than coronavirus. 

The rate of infection appears to be slowing in China but continues to grow rapidly in other countries and the impact of the virus on regional and local economies has been intense. The latest quarterly growth rate in Japan was -6%. We cannot confirm how Chinese industries are operating, but word on the street is something around 20% of capacity. 

Key Segments of the Economy

For the moment our economy continues to operate and stock markets remain open. Nevertheless, Investors anticipate a slowdown in U.S. growth – some even proclaim a recession – and a stagnation or outright decline in corporate earnings. Before you start believing this hyperbole, let’s look at key segments of the economy and the potential effects of coronavirus

First, the consumer segment is divided into three parts: those are spending for durable goods, nondurable goods, and services. Services is the largest and makes up about 64% of consumer spending. Some of you are probably asking, what is included in services? Well, housing and utilities, healthcare, financial services, recreation, transportation, food services, and accommodations. The coronavirus is already disrupting these service providers, particularly transportation, food services and accommodations. Just as you might expect, our outlook for this segment is much lower for the next two quarters. Spending on nondurable goods accounts for approximately 25% of consumer spending, and spending on durable goods accounts for 13%. Our opinion is coronavirus will affect supply chains and that is likely to lower durable goods spending over the next two quarters. Therefore, we our outlook for this segment is also lower.  Spending on nondurable goods, such as food and clothing, seems like an area that will be less affected. In fact, we are confident that growth will likely be the outcome for the next few quarters. 

Next is gross private domestic investment (GPDI). This segment was poised to recover from the partial resolution of the trade war, but the coronavirus will likely depress results for at least the next two quarters. The main components of GPDI are investment in structures (15% of the total), equipment (37%), intellectual property products (29%) and residential (18%). Investment in structures has been the hardest hit by trade tensions; with the onset of the coronavirus, we do not look for a turnaround in the near term here. Investment in equipment has also been weakened by the trade war; again, we do not expect this trend to reverse in the current environment. The strongest component of GPDI has been intellectual property products – software, R&D, entertainment. With people staying at home, this spending will likely be less affected by the coronavirus. Residential may be a mixed bag. Some homebuilders are already facing supply-chain slowdowns, but low interest rates should support demand. 

The third major segment of the economy is import/ export, and I want to emphasize a few things here. On the whole, we believe this segment will dramatically affected by the coronavirus. Now, let’s go through this carefully because the math works differently in this segment. First, we expect a slowdown in exports – that is, goods and services sold to other countries – clearly a negative for the U.S. economy. Imports, on the other hand, subtracts from U.S. economic growth. That means as imports from countries affected by the virus are reduced, the result is positive for U.S. economic growth. 

The fourth and final segment of the economy is government spending. After years of sequestration in Washington, the federal government has been accelerating spending in the past year. Also, considering that this is an election year, we look for the strongest economic growth trends in 2020 to come from government spending. All in all, we have lowered our economic growth forecast for 1Q20 to 1.5%, and look for only 1.9% growth in 2Q20 and for the year as a whole. 

The onset of the coronavirus is one thing. The reaction to the coronavirus could be something else entirely. The virus could elude containment, or mutate, and lead to stricter quarantines, effectively shutting down the economy. The next several weeks will offer clues on this, as the growth rate of new cases in China appears to be slowing. But even without a harmful mutation or an upsurge in cases, our current estimates could face downward revision if consumers and businesses cut back sharply on travel and consumption. Make no mistake, that is a real risk that is hard to accurately quantify since no one can predict what the reaction is going to be. 

At this point, investors have reacted by moving to risk-off investments, such as Treasury bonds. The yield curve has inverted again, and the Federal Reserve lowered rates and talk is on the table about additional cuts.  In our opinion, however, we don’t see this as a prudent move – what does it solve?  Let me put it like this - the Fed’s rate cuts are designed to increase demand, but the current economic weakness is coming from the supply side, not from a lack of spending.  In fact, consumer spending remains healthy. With all due respect, cutting rates cannot fix supply issues.   Our view is the Fed has very few tools at this point but a decisive and pre-emptive policy response could go a long way.  Given the uncertainty around what will likely be a significant economic disruptor, we think a sooner than later attitude is appropriate.  Assuming we have fiscal stimulus from the White House, it likely includes things like more spending to rebuild the nation’s infrastructure instead of simply focusing on tax cuts. President Trump cleared the first hurdle in what I believe is the most important of the solution, he signed into law The Coronavirus Funding Bill. One of the most critical parts, however, is survival of small business. This segment of business represents the largest part of employment so they must be supported. Production disruptions and financial shortfalls can lead these small, but valuable employers to extinction.  Bottom line, explicit fiscal policy could help us avoid our next recession. 

Insider Trading

Stocks remain on a wild ride that mostly goes down. Yet something else also is taking shape: exceedingly bullish insider sentiment in the midst of broader market pain. When the market carnage started, corporate insiders looked the massive selling right in the eyes and responded by buying. Now, with the stock-market decline gaining momentum, insider-sentiment data from Vickers Stock Research shows that insiders are buying up shares and the volume is convincing. This gives additional weight to the sentiment that comes from those transactions. We are not saying that insiders have a crystal ball, but assuming this health crisis follows the same path to resolution as those that came before it, insiders seem to see value in the current pricing of stocks. 

We have been talking with clients over the last few weeks and continue to remind them that now is a time for to keep a long-term perspective. Part of the comprehensive planning that we deliver considers major events.  Stress testing for our clients is one of the best values we provide and should provide comfort during periods of unstable markets and economic disruptions.The ultimate depth and duration of the coronavirus impact is uncertain, but we remain confident that its grasp is transitory, this outbreak will dissipate and economic activity will normalize. In the meantime, we are staying invested as our strategies are designed for long-term investors.  Now, don’t misconstrue that message.  We are very active and continue looking for value throughout the markets.  We are trimming positions and buying new positions in an effort to better position ourselves for a rebound.  Moreover, our rebalancing strategies provide opportunities that call for reducing over allocated asset classes and redeploying those proceeds to areas that offer better value. 

Let’s round out the call with a look at the Technicals

When it comes to technical, you can quickly get lost in the multitude of charts, oscillators, trendlines, and ratios.Knowing how to interpret these so-called signals presents yet another problem.  Well, we are going to provide a few simple thoughts on what the technical are saying and avoid the cryptic jargon that leads to a lot of confusion. 

First, let’s look at the VIX (or volatility index). This index is often called the FEAR INDEX.  When it moves higher, stock prices generally move lower.  When the vix moves lower, stock prices tend to move higher.  At this point, the VIX is trading at well above average levels – naturally stock prices are moving lower.  So how can this FEAR INDEX help us read the markets.  Well, in our opinion, this single metric cannot accurately call tops or bottoms.  Instead, we believe it is best used in combination with other indicators.Separately, it should be used to determine above average risk and below average risk. 

Next, puts and calls (also known as options) can provide some idea of how traders are looking at the near term trading environment.When we divide the number of puts by the number of calls, we get a ratio that is easily charted.  When this ration rises, the market is expected to move lower.Presently, this ratio remains elevated, much like you would expect. That suggests a bearish sentiment.

Lastly, let’s talk about the Stocks to bond ratio.  Just like puts and calls, a ratio of stocks divided by bonds provides some indication of overvalued and undervalued assets.  The recent plunge in stocks and the parabolic move in Treasuries moved the stock/bond ratio to one of its most undervalued positions for stocks, and one of the most overvalued positions for bonds, and I am not talking about looking back for a few years.  Actually, I am talking about five decades. Now, some of this is due to historic plunge in yields. On the bearish side for stocks, some breadth indicators have become so oversold that they have moved to potential danger levels for stocks. The percent of S&P 500 stocks above their 200-day average has fallen to 17% as of Monday’s close. The worst market declines tend to come when this breadth measure is below 45%.  So, what does all this mean? 

Well, to sum it up, stocks have clearly moved into a bearish mood and bonds have been exceedingly bullish on a relative basis.So, from a technical standpoint, we believe that stocks may have a little more downside before things improve.Bonds, conversely, appear overvalued with very little room to move up in value.  Depending on your capacity for risk, this could be a good time to rotate some of your fixed income to stocks.  Yes, I know this sounds counterintuitive.  That’s because it is opposite what seems natural.  Think about it like this, when stocks move higher, is it perfectly normal to rebalance – sell some higher priced stocks and buy some undervalued bonds.  In this case, stocks are under-performing and bonds are outperforming.  Shaving some of the gains from bonds to buy stocks have sold off in recent weeks is nothing more than rebalancing.  Except in this case, the asset class that outperformed happened to the one that is expected to underperform. 

Roger, thanks for joining me today. Until our next podcast, remember to stay calm and avoid emotional impulses that may not be justified. Remember, impetuous decisions based on the medias passion for selling fear is not a strategy. Try to avoid obsessing over thinks that are unlikely to derail a well-designed strategy.   If you don’t have a strategy, contact one of our associates. We will see you next time on We are Talking Money.