After recording two double-digit drops in equity prices over the last three trading days, the global pandemic of COVID-19 has sent world equity markets into bear market territory. The result is a cumulative 30% drop in the S&P 500 Index in just under 30 days. Though daunting, once the market finds a bottom, which is where the index begins to consistently move higher than the previous market low — and we believe it is “when” not “if” the market finds a bottom — it may provide an attractive opportunity for long-term investors to consider adding risk to portfolios.
These are extraordinary times. The global pandemic has caused significant worldwide economic disruption, driving stocks into a bear market for the first time in over a decade and sending U.S. Treasury yields plummeting. Major US cities have effectively gone into quarantine, entertainment and sporting events have been cancelled, large gatherings of people have been banned, schools have closed — and the list goes on.
While the health of those close to us remains our top priority, as investors, we also must try to assess the economic and market impacts. Recession odds have risen sharply, as it is becoming clear the impact on economic growth and corporate profits — though temporary — may be significant. Powerful monetary and fiscal stimulus actions and more aggressive containment measures may likely help mitigate the impact, but it’s tough to see the other side from where we sit today.
Before getting to our investor playbook, we would first encourage long-term investors to consider staying with your long-term investment plans.
We believe having a systematic playbook to follow can help us manage through these tough times. When those difficult times are caused by bear markets, a playbook can make clear what to watch as “leading indicators” of a potential market bottom that may signal the start of a sustained move higher. This playbook may help ease concerns by taking some of the emotion out of investment decisions and facilitating a measured approach. We all want to know when and where the market will bottom, the likelihood of a potential recession, and when the outbreak will be contained. These are extremely difficult questions to answer — but this playbook is designed to provide some clarity.
Foremost, we need to identify the most important signals, shown in Figure 1, that can help us determine when the market may find its footing. It’s important to note that having all five of these signals turning positive is not required before attractive entry points might be considered. Currently, the majority of these signals are either already or close to signaling that a potential bottoming process may not be that far off.
Key signals for the playbook
Confidence in the timing of a peak in new COVID-19 cases in the United States. The number of new US cases continues to rise, and we don’t know when or at what level they will peak. Based on the experiences in China and South Korea, we think the peak is coming within the next month. However, the experience in Italy suggests perhaps it could take longer. The key is not to wait until the peak in new cases has materialized, but rather developing the confidence in the predictability of the pandemic’s outbreak path using sophisticated epidemic models, like Farr’s Law, which has successfully modeled disease spread through populations in past pandemic episodes. We see confidence in the timing of a peak as a major milestone in the stock market bottoming process as in past pandemics, the market has usually found its trough in prices tied to the stabilization of new cases, not necessarily the visibility of declines. We continue to monitor new cases daily and watch for signs of what path the US may take to.
Visibility into the probability and severity of a US recession. We won’t know for sure if the US economy has entered a technical recession for many more months—since you only know you’re in a recession in hindsight. However, we will likely see data that indicates the timing and severity of a potential recession very soon. We will be watching the most timely data points to help gauge the depth and severity of a possible recession, including the March Institute for Supply Management (ISM) surveys, consumer confidence, jobless claims, and the Leading Economic Index, among others.
Has a recession already been priced into markets? We think we are already there on this one. A nearly 30% decline in the S&P 500 Index from the February 19 record high is consistent with a typical recession. We can also point to valuations. For example, if we cut current S&P 500 earnings by 10% and apply a reduced price-to-earnings ratio (P/E) of 15, we get to an S&P 500 level of about 2,200, which we think is a reasonable recession-level downside target. We can also look at the equity risk premium, which is the difference between the earnings yield (earnings-to-price ratio of E/P rather than P/E) and the 10-year US Treasury yield. At over 5%, the equity risk premium is nearing the 6% level seen at the market lows in 2008–2009.
Sentiment and technical analysis indicate limited number of sellers remaining. To assess whether most aggressive sellers have been forced out of the market, we can look at investor surveys or technical indicators. Survey data such as the CNN Fear & Greed survey and the American Association of Individual Investors (AAII) survey reflect some of the most negative readings ever registered, a potential contrarian signal that most of the selling pressure could be behind us. Additionally, a historically high number of stocks are oversold, potentially a bullish combination when combined with the extreme negative sentiment.
Will policymakers’ response be sufficient to restore confidence? We think we are getting close to getting this signal. The Federal Reserve is pretty much “all in,” having effectively cut interest rates to zero while adding another round of quantitative easing (buying bonds) and more liquidity to ensure credit markets function. We have a very aggressive monetary policy, but what is needed now is a strong fiscal policy response, including targeted support for individuals and businesses most impacted by the crisis. We expect meaningful progress to be made this week in Washington, D.C., toward what could eventually exceed $500 billion in total stimulus.
Overall, we are getting closer to reaching all of these conditions, and an inflection point for the direction of markets may be approaching.
Revised economic forecasts
In response to the impact of the pandemic on the economy and markets, we have updated our forecasts for 2020 [Figure 2]. We have lowered our gross domestic product (GDP) forecasts for the US, emerging, and developed international markets, as well as global GDP. These forecasts reflect a greater than 50% chance of a short-lived economic contraction in the United States. We believe the strength of the US economy prior to the outbreak may help it weather the storm.
Finally, our revised year-end 2020 fair value target for the S&P 500 of 3,150–3,200 is based on a P/E of 18, supported by lower interest rates and S&P 500 EPS in 2021 of $175, a slightly above-average earnings growth forecast for next year coming off potentially depressed profits in 2020. Investors may have to wait longer for those earnings in 2021 to come through, and the outlook is clearly uncertain, but we have more confidence in next year’s earnings than this year’s. In a recession scenario in which earnings may be heavily impacted, we may see a downside scenario on the S&P 500 of around 2,200 or potentially lower.
We believe stocks have fallen to levels that are very close to a market bottom such that the next phase would be an upward-trending market. At that point, we would consider the environment very attractive based on our assessment of economic and market fundamentals. At that point, we would be thinking about upgrading our equities recommendation to overweight from market weight, which we lowered from overweight in March 2019 after stocks got off to a strong start to the year. But we want to err on the side of caution, which is where our playbook comes in. We will continue to monitor new COVID-19 cases, economic data, and policy news to determine an appropriate time to make an adjustment.
For now, our best advice for long-term investors would be to consider staying the course while we wait for more signs of progress in terms of the market’s bottoming process.
But just like always, I am here to help you and your family answer any questions regarding your investment strategy that might surface. Whatever decisions you’re considering, I’d be honored to support you through them. Reach out to me anytime…
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
All investment involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.