If you look back over the last century, you’ll find three types of events that have greatly disrupted stock markets leading to market declines and levels of volatility that are reminiscent of the market reaction being triggered by the Coronavirus outbreak. Each of the events mentioned below triggered single day market declines and rallies on the order of the huge swings we’ve seen over the last week.
- Economic Catastrophes: The Depression in the 1930s, the stagflation of the 1970s, and the Financial Crisis of the late 2000s, were all catastrophes rooted in destabilized economic systems.
- Social Catastrophes: World War II and the start of the Arab-Israeli War in 1948, were catastrophes rooted in destabilized social systems.
- Financial Market Catastrophes: The crash of 1987, which saw the US stock market fall 20% in one day, was a stock market disruption that was rooted not in external economic or social factors but was a function of the financial market system itself becoming destabilized.
With Coronavirus we now have a fourth type of catastrophe triggering a market decline and volatility on par with the previously known types of events listed above. While readers with a good sense of history might point to the Spanish Flu pandemic of 1918-1919 as being potentially similar to Coronavirus, the US stock market actually rallied 10% in 1918 and 30% in 1919.
In the case of economic and social catastrophes, the large scale and persistent disruption of underlying economic and social order has generally led to impairment in the intrinsic value of public companies, which is why the resulting stock market declines continued for some time. But in the case of the financial market catastrophe of 1987, the underlying economic and social order was not disturbed and so the stock market was relatively quick to recover. In fact, the two years after the crash of 1987 saw a relentless 60% rally.
While the decline in the US stock market over the last month was not triggered by a financial market catastrophe as the 1987 crash was, the global natural catastrophe of the Coronavirus has, over the last week, triggered a destabilization of financial markets. That has been most clearly evident over the last couple of days with certain segments of stocks falling 20%-30%, while previously even the big down days mostly saw individual stocks trading down along with the market, not going down dramatically more. It is also evident in the stresses that have appeared in fixed income markets, which former Federal Reserve chairs Ben Bernanke and Janet Yellen discussed in a Financial Times op-ed today.
So there is a portion of the decline seen over the last month that is attributable to destabilized financial markets. Even if the global economy rolls over into a severe recession, the financial markets will re-stabilize as they did during the Depression and the Financial Crisis and thus pressure being put on stock prices from a destabilized financial system will abate. But that will still leave behind the very serious concern that Coronavirus will cause such a prolonged shut down of the global economy that we will roll over into a prolonged recession.
It is important for investors to recognize that Coronavirus is a unique and novel event in stock market history. We have never before seen a global natural disaster have the scale and scope of impact that we are seeing on stock markets around the world nor one that has led to global economies literally shutting down in near unison.
When you face a novel situation, it can be very, very difficult to know what to do. The first step is to recognize that the situation is without precedent. The second step is to go back to first principals and assess how the novel situation may impact what you are trying to achieve. The third step is to review the strategies you were previously deploying and make any needed adjustments based on the new level of uncertainty and your best forecasts of the impact of the novel event.
This is the series of steps we’ve been going through at Ensemble over the last month. Our first post on Coronavirus discussed the extremely high level of uncertainty that accompanies the forecasting of pandemics. Our second post on Coronavirus attempted to frame the economic impact of this novel event. Our post earlier this week reviewed our core investment philosophy and confirmed that while we believe Coronavirus will have a very large, meaningful impact on the economic and social environment in which companies operate, it does not invalidate our core investment philosophy of investing in dominant companies, with large competitive advantages, excellent management teams, and business models that we understand deeply.
The question on everyone’s mind now is what is going to happen next. Will the stock market make a relatively quick recovery once Coronavirus cases stop rising and the extent of the outbreak becomes clearer? It is hard to believe that could happen right now, but it is notable that this is exactly what happened in China once new cases stopped increasing and before investors understood that the viral outbreak would impact global economies.
Here’s a chart of the Shanghai stock exchange, which after falling sharply in January and February as the Coronavirus spread, quickly erased all of the Coronavirus related decline by early March.
Now to be clear, we are not suggesting we think the decline in the US stock market will reverse over the next month. We are just observing what happened in China, which is the first country to have been hit by Coronavirus. So it is worth exploring why China bounced back when it did. The chart below shows the growth of cumulative confirmed cases in a range of countries, but the start date for each country is the day when the case count in that country exceeded 100. The lines flatten out once the number of new cases each day starts falling.
Notice how the rate of increase was initially exponential in China, but a couple weeks after Wuhan went into lockdown the rate of new cases slowed dramatically. As the exponential growth rate rolled over and slowed dramatically, it became clearer what the eventual scale of the impact would be and so the level of uncertainty that had knocked down the Chinese stock market was sharply reduced, and the market rallied.
Today we know that just three weeks after the lockdown was declared, the Chinese economy started coming back to life. You don’t have to put your trust in Chinese government statistics to see this. You can simply observe that Apple began reopening stores in China in mid-February and that today all of Apple’s stores in China are open.
The fact is that today we do not know when the US and Europe will hit similar inflections with new cases beginning to slow. The good thing is that the dramatic actions taken this week in the US and Europe are the beginning of what is needed to get new cases under control as quickly as possible.
The panic last week in the US market was about investors coming to terms with the scale of the Coronavirus threat. But the panic that all of us as people feel this week is not actually in reaction to new information about the virus, but to the social panic triggered by the shut down orders imposed in some cities and the closing of borders around the world.
Yet these panic inducing actions are what is needed to get us to the point of declining new case counts as fast as possible.
If people didn’t panic, then the Coronavirus would continue to spread unabated throughout the population. But the panic inducing realization of the scale of the threat has triggered a scattering of the population to distance themselves from each other on a scale never before seen in human history.
We don’t know if the actions taken in the US and EU are enough to cause a slowdown in new case counts. If it is, our understanding is that the slowdown should become apparent over the next two to four weeks. But without widespread testing, we may not even be able to observe whether or not the shutdown is actually working.
There is no doubt that there will be great economic harm as a result of the shutdown. However, there would be even more if the virus was allowed to run rampant instead. The key for investors will be trying to come to understand if the rate of new cases can be slowed quickly enough that shutdowns and other social distancing mandates can be lifted in time for the economic damage to be dramatic, but short lived.
With both monetary and fiscal authorities now taking unprecedented action, there will be a strong boost to the economy that hopefully can jump start it back to growth. To give you a sense of how large this stimulus is and how quickly the political winds have changed, on Friday Congress only barely was able to agree on a $50 billion stimulus package while yesterday the president proposed a $1.2 trillion package or 24 times larger than the package on Friday.
The US stock market has already experienced a 30% decline from the high in mid-February. In a typical recession the market tends to decline about 20% to 30%, or in severe recessions more like 30% to 50%. Investors should recognize that if we “only” get a harsh economic shock that impacts the next six months or so of 2020, followed by a stimulus fueled rebound that begins near the end of the year and carries into 2021, the market may well have already priced that in and a strong rally may begin as this outcomes becomes more clear in the coming weeks or months.
The size of the impact over the next six months is almost certainly going to be large enough to be defined as a recession. We’re not talking about avoiding a recession, only about the potential for the recession to be very, very sharp, but short lived, and followed by a very rapid rebound.
But of course, investors must also always accept that worst case outcomes do occur from time to time. It could be that the US and Europe are unable to get Coronavirus under control soon enough to avoid the economy rolling into a larger more prolonged recession. This isn’t just a risk related to Coronavirus, severe and prolonged recessions are something that have happened multiple times over the last century. They are brutal experiences, but when you think about the long-term rate of return to equites of about 9%, this is inclusive of the severe recessions that have occurred during that time.
If the Coronavirus is going to trigger a global severe recession that persists, we can look back to how the stock market behaved during the financial crisis to see what sort of expectations we should have. Even after the US stock market had declined by 30% in early October 2008, we know in retrospect that there was still much more downside still to come. However, the market hit its bottom in March of 2009, just five months later and from early October 2008 to early October 2009, the stock market generated a small gain. The two-year cumulative return starting from October 2008 was 15% and the five year cumulative return was 79% or over 12% per year.
In the words of Mark Twain, “history does not repeat itself, but it often rhymes.” We do not have a corollary for the global natural disaster of the Coronavirus. We cannot know if the shutdowns sweeping the globe will cause a painful but temporary economic contraction or a prolonged, severe recession similar to the financial crisis. But we do know that at this point in the decline during the last prolonged recession, equity investors who could hold stocks for one, two, five or more years were handsomely rewarded with solid positive returns. Doing so required investors to endure more downside pain from the point we are today, but the risk of a sudden decline in the stock market is an ever-present risk, not one that is unique to today.
Should the economy not rollover into a prolonged and severe recession it only makes sense that returns to equity investors will be dramatically stronger.
We know that we can’t predict what is going to happen with the economy. Medical experts can’t predict what is going to happen with Coronavirus. But we do know that the companies we hold in our portfolio are led by outstanding management teams, protected by significant competitive advantages and will steward our clients’ capital as well as possible through this crisis as well as the future crises that occur in the decades ahead.
Importantly, from a business perspective, weak companies may not make it through the unprecedented halt to economic activity that is hitting the US and Europe right now. On the other side of this crisis, the competitive playing field in which our companies operate will be in disarray with many competitors sidelined or even out of business. It is in this period of economic disarray that the very best companies move to the forefront. Their outstanding management teams take the opportunity to spring back into action, serving their customers needs and desires while other competitors are simply unable to do so.
This is when the best companies shine.
We are safe and well here at Ensemble Capital. We hope you are the same.
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