Investor complacency finally was broken in late February.
In the 11 years since the bull market began, investors ignored a lot of reasons to sell stocks, especially in the last few years. We never know what will begin a market correction or bear market. We do know that when markets climb for so long, become so highly valued and have such a small margin of safety, some event or series of events will be the trigger or last straw that leads to at least a temporary downturn. The event will be unanticipated, because expected and known events are priced into markets.
Market momentum reversed in late February on the joint news that the coronavirus was spreading rapidly, and that Bernie Sanders had a realistic chance of becoming the Democratic presidential nominee. Though the coronavirus dominated the news, as I said in Bob’s Journal at the time, I believe there were multiple reasons the markets turned south so sharply.
The markets quickly priced in a very severe and sustained global downturn. While declining stock prices reveal pessimism, the extent of the pessimism is exposed in the significant declines in treasury bond interest rates and prices for oil and other industrial commodities.
Gold’s strong rally also is evidence of pessimism.I view the economic effects of the coronavirus as temporary and not likely to be as severe as what was priced into the markets. I expect the spread of the virus to peak and come under control sometime this year, hopefully by mid-summer.
The economic downturn from the coronavirus is going to be meaningful, and some industries and countries will suffer more than others.But I believe most of the economic damage will be temporary, unless this outbreak is meaningfully different from previous outbreaks. The coronavirus isn’t destroying capital the way the financial crisis did. Instead, economic activity is freezing temporarily and there’s a build-up of unsatisfied demand. More serious and potentially lasting problems are likely from the steep decline in the price of oil that was triggered by Saudi Arabia’s declaration of a price war on March 9.
Saudi Arabia tried this in 2014 as a strategy to break the U.S. oil fracking industry. That move did more damage to the Saudis than to the fracking industry. The Saudis apparently believe this is a good time to try again. The effects of the coronavirus are a shock to the system, not a systemic change. The oil price drop is likely to be a more systemic change if it persists. I anticipated a strong snap back in economic activity and stock prices once normal activities resume after the coronavirus runs its course. The secondary effects of what’s happening with oil could overshadow that.
Businesses and individuals with a lot of debt face the most serious problems. During the slowdown, they might not be able to service their debt.
The good news is the financial system is in solid shape, much better than when leading up to the financial crisis. Most financial services companies aren’t as extended and leveraged as when the financial crisis hit. Another sign of strength in the financial system is that interest rates on non-government debt didn’t spike higher as the coronavirus crisis expanded.
Central banks have learned a lot and are better prepared. They’ll provide liquidity even before it’s needed. Keep in mind, though, that the central banks don’t have a lot of tools available to them, as I’ve been saying for about six months. We saw proof when the Federal Reserve cut inter-est rates on March 3 and the stock market started tumbling instead of recovering. Investors now know the central banks can provide limited protection, and that’s another reason that stock prices declined.
Once the spread of the virus is contained, economic activity will start to return to normal. But now that investors know the Fed can’t always support stock prices, investors will focus even more on valuations, the drop in oil’s price, the election, the weakness of central banks and the need for strong fiscal policy.
With markets already pricing in a significant economic decline, this isn’t a good time to make major changes in your portfolio. We entered the down-turn with well-diversified portfolios and investments that had margins of safety. As you’ll read in Portfolio Watch, these policies are preserving capital better than most strategies.