As of today, the S&P500 is down about 20% from its high set earlier this quarter and the Coronovirus has spread throughout many US cities and entire regions in Europe and Asia. While the world is witnessing various subsets of its economy shut down for public health reasons, we are observing various responses in different economic areas. As one example, the Saudis (in an effort to maintain positive cash flow in their region during this period of record setting reduced demand for oil) have launched a campaign to produce the lowest priced oil in the world, in hopes of gaining market share from regions usually supplied by Russian oil. Since energy companies make up a noticeable component of the S&P, it has put further drag on stock prices. In the US, we see travel, entertainment and sports industries announce cancellations or "no fan" events which will take a bite out of 2020 profits for certain.
The big question that everyone wants answered is: “When will this downdraft end?” Although no one really knows the answer, I think that it is helpful keep in mind how the market prices stocks on the exchanges. The key variable is projected earnings. Stocks sell at a multiple to the projected earnings of the company for the next 12-18 months. Historically investors in the US pay about 17x earnings for stocks on the S&P. In times where optimism and positive events are happening in the economy, investors may get excited and pay more. We saw S&P multiples move up to 19.4x earnings in late January which, in our opinion, was mostly unfounded excitement. In times where fear and worry grip investors, such as in the midst of the financial crises, we saw investors only willing to pay 12x earnings for stocks. So there are ultimately 2 main factors, forward projected earnings AND price to earnings multiples, that drive the price of stocks.
Let’s consider what is happening with this particular global crisis. Both earnings and multiples are declining. First off, the Coronovirus is halting many different types of economic activities which is driving down companies’ abilities to make product, deliver goods, provide services, etc. all around the globe. As a result, current year projected earnings are declining noticeably. At the same time, the public is becoming more and more impacted by the spread of the virus. Fears are setting in for not only public health concerns, but also for people to have confidence that companies will be able to make profits during this bio storm. So, naturally investors are selling stocks because it’s a higher risk that stocks would be a good bet at high multiples as more systems may be further impacted by the virus.
As we said in our last update, the primary problem for the stock market with the Coronavirus is that it poses systemic risk to the economy. The nature of a public health hazard of this magnitude is that it shuts down entire segments of the economy for periods of time. It is not predictable, so it becomes an impossible calculation to determine how much earnings will be lost during the contagion period. When investors cannot calculate the “worst case” scenario, many assume there is no bottom and just sell versus trying to invest on the speculation that everything will resume business as normal at some point in the near term.
Based on all of these contributing factors, our view is that the market could continue to decline an unpredictable and even an irrational amount, before it stabilizes and returns on a path to normalization.
For our AFP Defined Risk clients, we began reducing stock exposure using our trend strategy (AFP Defined Risk Strategy) back in February and have been reducing stock exposure over the past couple of weeks. Growth and Aggressive portfolios have enough stock exposure that your would expect to still see account movement on big moves in the market and our more conservative strategies have such diluted stock holdings at this time, that it is likely further declines in the market will have much impact at all..
As most of our clients check their balances and their year to date returns, although most are slightly negative for the year, I think most everyone will be surprised how well their returns are compared to the stock market (S&P currently at -15% for the year, and the international indexes are even worse.). Part of the reason for the surprising low impact of this global crisis on your money in these strategies is not just the reduction in stock ownership, but also the unexpected short term positive returns for many of the bond positions that we own. As the Federal Reserve and the bond market have pushed rates to unprecedented lows, this has helped to buoy bond heavy portfolios during this crisis.
Obviously each individual client situation is uniquely different and you may have some slight variances in your accounts from our managed account targets described above, but I feel that this overall information may help you have a better understanding of what is going on with the world economy, what could happen from here, and how we are responding with how our management process overall.
I wish there were enough hours in the day to call each of those we serve and make sure you understand this information, but unfortunately there is not. If you have individual questions, comments, or concerns, please do not hesitate to call the office or email us. We are working diligently to keep everyone informed as we journey through this period together.