The entire process, from the time I begin to compose My Gut Feeling to when I send out that email which you receive, takes three to four hours. Since the equity markets began to cascade lower on Monday February 24, I set out to write My Gut Feeling on two occasions. Both times, I decided to hold off as I was not convinced that all the facts were in and there was more to the correction than meets the eye. Parenthetically, today’s installment took even longer, and I stretched it out over two days for final publication.
5 Causes of the Correction
Corrections happen. They are a natural part of the investment process. The Standard & Poor’s 500 (SPX) peaked, on a closing basis, at 3,386.15 on February 19 and on an intraday basis the same day at 3,393.30. So far, the correction low of 2,856.14 was reached on Friday, February 28, a decline from the intraday peak of 15.83%.
I can, with 100% confidence pinpoint five (5) causes of the correction.
- 1 – P/E Contraction – After a solid bull run for the past several months, the markets were simply overstretched to the upside on a valuation basis. The P/E ratio of the SPX was about 19.5 times estimated earnings. A reasonable pullback of about 5 – 7% purely on P/E contraction was in the cards. We just needed a reason for a pullback, and we seemed to get a few of those (See #s 2 – 5 below).
- 2 – The Bernie Sanders Effect – On Saturday February 22, Bernie Sanders, the socialist (and perhaps communist) candidate won the Nevada Democratic Caucus. The markets do not want to see a socialist in the White House. Then the next day, Sanders was interviewed for CBS’s (VIAC) 60 Minutes TV magazine by Anderson Cooper. It was, to say the least, a shocking interview, that is unless you are fond of Fidel Casto. During the interview, you could watch SPX futures materially turn lower. The following day, the SPX declined 3.35%. Also on that day, Sanders released his plan to pay for all of his progressive programs which of course was not market friendly.
- 3 – Coronavirus – without any Democratic primaries till Sunday February 29, all that the media had to talk about for the rest of last week was the Coronavirus. Coverage of the virus was across all media outlets on a 24-hour basis. In no uncertain terms, coverage was ubiquitous and unavoidable. Having very little information about the virus, all that the media could was to engage in extrapolating the impact of the virus into a full-fledged panic. This was the financial equivalent of shouting fire in a crowded movie theater. The result was an 8.42% decline in the SPX for the balance of last week.
- 4 – Federal Reserve – this Tuesday, March 3, the Federal Reserve, in a move between regularly scheduled meetings, cut its target Fed Funds Rate by 50-basis points. This unexpected move initially was met with mild market approval. However, during FOMC Chair Jerome Powell’s press conference, it became abundantly clear to the market that Powell was did not have control of the monetary markets and lost any market confidence he might have had left, The result was nearly another 3% decline for the SPX. It was incorrectly assumed by the naïve market observer that Powell was doing a good job by lowering rates. Rather, his decision was dictated to him by the fixed income markets which already priced in with nearly 100% certainty a 50-basis point cut in Fed Funds. I would also add that investment managers have long memories and they still blame Powell for the 2018 fourth quarter debacle.
- 5 – Yield Curve – all that #s 1 through 4 did was drive interest rates lower. A huge rush to buy bonds, in a panic to safety, drove the yield on 10-year US Treasury below 1%.
Offsetting the above causes for the correction are two positive factors:
a) The Joe Biden Effect – this is the mirror image to the Bernie Sanders Effect. After winning the South Carolina Democratic primary last Sunday, markets had a glimmer of hope that Bernie Sanders was not a shoo-in for the nomination. On Monday the SPX surged 4.6%. Then yesterday, following Joe Biden’s Super Tuesday primary results, the SPX tacked on a gain of 4.22%.
b) The 10-Year Treasury vs. SPX Yield – after the valuation correction, markets woke up to a sober reality that the SPX Dividend Yield of 2% was twice that of the 10-Year Treasury Yield of 1%. I don’t recall the last time, if at all, that the ratio of those returns was 2-1. Put another way, if you invested $1,000 of your money in US Treasuries for ten years, you would have, without compounding, $1,100 in ten years. To return the same amount in stocks, the SPX would have to DECLINE 10%. Any decline of less than 10% in the SPX or gain, would tip the risk reward in favor of stocks. Thus, stock versus bond valuations are getting too cheap to avoid.
Stock Market Reaction
Over the past few days, the media’s reporting on the coronavirus is far less panic driven and more rational. Despite more instances of the virus being reported and more deaths occurring, we have more information and less speculation with respect to the spread and veracity of virus information. Markets are accepting that there will be impact to domestic and international economies, but such impact will be for one or two quarters and civilization as we know it will survive.
Analysts are divided as to whether a retest of the recent market lows are to be expected or whether the worst of the correction is in the rear-view mirror. In my opinion the worst is over, but we should expect more day to day market volatility. Take today for example, overnight rumors leading up to Thursday’s market open that Elizabeth Warren would drop out of the race and endorse Bernie Sanders put the Bernie Sanders Effect into play. When she did make her announcement without any endorsement, uncertainty rose, and markets fell further. Flipping between the Sanders and Biden Effect will be commonplace for the next few months.
Investment professionals are dumbfounded by the random direction and magnitude of recent daily market moves. Include me as sharing that sentiment.
Here is a table of the daily index and percentage changes for the SPX since the beginning of February. Note those big moves both up and down in the past nine sessions:
|SPX INDEX CLOSING LEVEL||SPX INDEX DAILY CHANGE||SPX INDEX % DAILY CHANGE|
|Thursday, March 5, 2020||3,023.94||(106.18)||-3.39%|
|Wednesday, March 4, 2020||3,130.12||126.75||4.22%|
|Tuesday, March 3, 2020||3,003.37||(86.86)||-2.81%|
|Monday, March 2, 2020||3,090.23||136.01||4.60%|
|Friday, February 28, 2020||2,954.22||(24.54)||-0.82%|
|Thursday, February 27, 2020||2,978.76||(137.63)||-4.42%|
|Wednesday, February 26, 2020||3,116.39||(11.82)||-0.38%|
|Tuesday, February 25, 2020||3,128.21||(97.68)||-3.03%|
|Monday, February 24, 2020||3,225.89||(111.86)||-3.35%|
|Friday, February 21, 2020||3,337.75||(35.48)||-1.05%|
|Thursday, February 20, 2020||3,373.23||(12.92)||-0.38%|
|Wednesday, February 19, 2020||3,386.15||15.86||0.47%|
|Tuesday, February 18, 2020||3,370.29||(9.87)||-0.29%|
|Friday, February 14, 2020||3,380.16||6.22||0.18%|
|Thursday, February 13, 2020||3,373.94||(5.51)||-0.16%|
|Wednesday, February 12, 2020||3,379.45||21.70||0.65%|
|Tuesday, February 11, 2020||3,357.75||5.66||0.17%|
|Monday, February 10, 2020||3,352.09||24.38||0.73%|
|Friday, February 7, 2020||3,327.71||(18.07)||-0.54%|
|Thursday, February 6, 2020||3,345.78||11.09||0.33%|
|Wednesday, February 5, 2020||3,334.69||37.10||1.13%|
|Tuesday, February 4, 2020||3,297.59||48.67||1.50%|
|Monday, February 3, 2020||3,248.92||23.40||0.73%|
Leading up to the market peak on February 19, the SPX traded in a normal manner. That is a good pattern in a bull market. The all hell broke loose after the Nevada caucus.
Not only is irrational behavior evident in the stock market, but also some consumer behavior is illogical. For example, sales of Corona beer, which is brewed in Mexico and distributed by Constellation Brands (STZ) is plummeting. Consumers are hoarding rice, water and toilet paper. That might make sense for flu viruses which affect the stomach and abdomen. However, coronavirus is an upper respiratory disease for which symptoms are fever, cough and shortness of breath.
Unfortunately travel – domestically and internationally – are being cancelled or delayed. This impacts the airlines, cruise industry, hotels / resorts and restaurants.
Today the February labor report will be issued, adding another variable into the equation. For the month, 175,000 non-farm jobs are expected to be added to the economy with an unemployment rate of 3.6%
I spoke with several practitioner doctors and a biomedical researcher the past few days to get their opinion on the virus. With the exception of one doctor, the consensus was that the panic associated with the virus was overdone, it will diminish like other flus in April or May, US and international governments efforts to prevent the spread of the virus will reduce the spread and kill rate of the virus.
What we need is fiscal stimulus, not monetary stimulus. Unlike his predecessors who would have open lines of communication with Congress, Powell by all appearances is acting in a vacuum. Congress has already passed one bill to help fight the coronavirus. I suspect that consumer-friendly fiscal stimulus is on the way.
As for stocks, try to stick with large capitalization companies and avoid small capitalization stocks. You might want to allocate some part of your portfolio to biotech stocks in hope of discovery of a vaccination to treat or prevent the virus from spreading. Travel related stocks will be in the doghouse for the foreseeable future. Believe it or not, the coronavirus will just add to the importance of 5G technology.
Take precautions as medical experts have espoused. As for the stock market, hang in there as the large swings and downside action will dissipate. We are still in a long-term bull market but you must recognize that sometimes markets will experience counter directional corrections.
Disclosure: At the time of this commentary Scott Rothbort, his family and/or clients of LakeView AssetManagement, LLC was long STZ, SPY, SSO & SPXL – although positions can change at any time.
Scott Rothbort is the President & Founder of LakeView Asset Management, LLC, a registered investment advisor specializing in high net worth private wealth management. For more information on investing with LakeView Asset Management, LLC call us at 888-9LAKEVIEW or request more information by clicking on the contact button on the top right-hand corner of the website. LakeView Management, LLC is a Nevada LLC, with its principal office located in Henderson, NV and branch office located in Millburn, NJ
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