Exactly one month ago (February 19, 2020), the S&P 500 made a high just above 3393 before closing at 3384. We didn’t know it at the time, but that was the market top. All of the major market averages were above their moving averages. Sentiment was strong, though we were aware that China was going through a crisis with a nasty virus that seemed to be centered in and around Wuhan. Remembering the SARS and the Ebola virus concerns and how they ultimately had very limited market impact, investors were not prepared to discount the potential risks. After two mild down days, stocks began to sell-off more earnestly on Monday the 24th. 110 points, or -3% were shaved from the S&P 500. That was one of the more volatile days in the month, and a harbinger of things to (though we didn’t know it at the time). By market close on Thursday the 28th, the S&P 500 had moved below both of its uptrend lines. Stocks plunged at the open on Friday the 28th, but recovered much of their losses by market close. The first week in March saw stock prices rise for the first three days overall, and while the market fell Thursday and Friday, Friday’s close was higher than the previous Friday’s close. This seemed to suggest that the market might be building a base of support in the 2900 range. If only!
Over the weekend of March 7th-8th we began to see really scary information coming out of Italy and Iran. The medical establishments in those countries were overwhelmed. There was no way that we were going to keep the virus from meaningfully impacting the United States. Stocks plunged to their June 2019 support levels around 2745, which put a floor under the market for three days. When on Wednesday night the entire sports world shut down after an NBA basketball player tested positive for the virus, stocks gave way spectacularly the next day. Friday the 13th saw a strong rally back to the 2700 level based on a late day speech from the President suggesting he was finally taking the crisis seriously.
This past week has witnessed a procession of plunges and rallies making lower highs and lower lows as the market fully discounts the impact of shutting down major sectors of the economy for weeks or months. The market’s drop of more than 25% in 16 trading days was unprecedented in history – the previous record was 27 days in 1929. We extended the record to 30% in 18 days this week.
From my perspective, stocks have moved from well above fair value through fair value to below fair value. Admittedly, since we really have no idea what corporate earnings are going to be either this quarter or at least the next two quarters, estimating fair value is quite difficult. That said, NYU Stern Professor Aswath Damodaran created a useful chart as to what the S&P 500 would be worth given various levels of earnings loss in 2020 and recovery in future years. It implies that S&P 500 fair value was about 3030 on February 19th. According to Damodaran, if earnings drop by 20% this year and 75% of that is recovered by 2025, today’s fair value falls to about 2870. If you are more pessimistic and see earnings falling 30% and only half ultimately being recovered, 2550 is fair. Anything in the range of 2500 to 2700 on the S&P 500 makes sense to me at this point, and it is 2450 as I write this. Not dirt cheap but certainly worth a look if one has a time horizon of three years or more.
Obviously, we are still going to have some bad days. The infection and death numbers are going to keep going up. Unemployment is going to rise sharply in the near term. That said, it appears that the multiple plunges in the stock market over the past four weeks have discounted a great deal of the economic damage we currently expect. Cruise industry stocks are down 80% or more. Hotels chains are down 50-60% or more. Airlines have lost 2/3 of their value or worse. The most affected areas of the economy literally cannot drop as much in the future under any scenario as they have already fallen. It is very difficult to imagine that we are not much closer to the bottom than the top.
Volatility has not been confined to the stock market. The bond market has been as wild as I have ever seen it, including 2008. As volatile as 2008 was, basically one can say the high quality bonds rose and low quality bonds declined, based on the projections of default risk. This crisis started out that way as well. Long term bond yields declined, and prices rose fairly steadily until March 9th. Then high quality bonds began to fall and fall hard despite the extremely weak prospects for inflation. It appears that as the market for stocks and weaker quality bonds fell, higher quality bonds were sold in order to meet margin calls or provide liquidity. The price of exchange traded funds (ETFs) have started to diverge meaningfully from the net asset value of the underlying bonds due to illiquidity. We believe that it will be a matter of several days for volatility to subside in the bond market such that AAA-rated bonds will better reflect inflation projections. All of this does remind us that during a crisis we cannot always count on diversification to save us, because correlations across asset classes tends to converge. It is fair to predict that future portfolios may have to own fewer bonds as we search for other non-correlated asset classes.
For our part, we made our first across-the-board transactions in late February as stocks broke through their moving averages. In March we have opportunistically trimmed small cap, mid-cap, and value stock positions in the U.S., cut foreign stock exposure by about 3% (from an average of amount 16% to 13%.), and also cut back on BBB (the lowest rung of investment grade) bond exposure. Average cash in our portfolios has gone from 3%-6% (depending on risk tolerance) to 6%-18%. We are at price levels where it probably makes sense to start nibbling at bargains, but we would like to see more time go by such that we have increased confidence that those investors still inclined to panic sell will have completed their transactions. It has always been our investment philosophy to “lean-in” to markets where conditions are favorable and to lean away when conditions weaken. That’s where we are now. We are mindful of the fact that the possible announcement of an effective treatment for the virus could spark a massive rally at any time, so the notion of completely selling out of the market makes no sense to us because we could never re-establish positions fast enough.
Thank you, once again, for your trust in us. We are gratified for this and we work very hard to continue to earn it.
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 Aswath Damodaran, A Viral Market Meltdown Part II: Clues in the Debris, Seeking Alpha, March 13, 2020.