February 25, 2020

What Happened

Stocks continued to add to losses on Tuesday over coronavirus concerns. The CDC warned about a possible spread of the virus to the US. This led to the first back-to-back loss of more than 3% for the S&P 500 since 2015. The market is now down 7.6% over the past four trading days.

Our Take

When we initially downgraded equities to neutral in late January, we did so based on concerns of stretched valuations, frothy sentiment, and a long period of time without a normal correction. The coronavirus added another layer of risk. Thus, the near-term risk/reward had become less favorable.

While much uncertainty remains on the coronavirus, some of our near-term market concerns are starting to be alleviated as prices and sentiment get reset. However, time is often a key element of most market corrections, and we are still early in that regard. Following the recent selling pressure, we provide perspective on past corrections as well as fundamental and technical levels to help estimate where the market may find support.

Perspective on Bull Market Corrections

Since the current bull market launched in March 2009, the S&P 500 has risen almost 400% on a price basis. However, the upward path has been interrupted by 19 pullbacks of at least 5%. Every pullback came with uncertainty and bad news, including several viral-related outbreaks such as the Swine flu in 2009, the Ebola scare in 2014 and Zika in 2016.

While there has been wide variability around each correction—some were longer, some were shorter, some were deeper, some were shallower—there tends to be an element of time and price involved in each that resets expectations and improves the market’s risk/reward ratio. The corrective periods have lasted an average of 47 days (median 28 days) and have seen an average pullback of 9.4% (median -7.4%; deepest -19.8%). The correction is already nearing the historical average price pullback though it is early in time at only four trading days old.

What We Are Watching

It remains unknown how severe the coronavirus outbreak will become. Nevertheless, by looking at historical pullbacks, technical trends, and fundamental support levels, we can attempt to estimate market downside. This is not meant to provide a false sense of precision, but is instead a framework to help investors gauge the risk/reward. Barring a significant worsening in the spread of the virus, we estimate market downside should be contained within 5% to 7% from current levels.

As mentioned, the average pullback during this bull market has been 9.4%, not far from the current pullback of 7.6%. An average pullback places the S&P 500 near 3070 (Tuesday’s close = 3128).

From a technical perspective, this level matches the price lows reached last November and December and is close to the widely-followed 200-day moving average (currently 3045). This moving average has historically been used by many investors and traders as a level to buy into the market on a pullback.

Below that level, the 3000 area previously acted as a strong barrier for markets, and should now become an important price support.

Likewise, there is strong fundamental support in the 2900 to 3000 range, even when we stress test our assumptions. Following the market pullback, the S&P 500’s price-to-earnings (P/E) ratio has already fallen from about 19x to 17.5x. Unless US recession risks rise substantially, stocks should find support near a 17x P/E. Using this valuation level and applying a 5% haircut to 12-month forward earnings estimates (from the current level of $179 to $170), to take into account uncertainty on the coronavirus, keeps a floor under the market near 2900.
There is nothing that rules out the market trading to a lower valuation; the S&P 500 traded as low as a 16x P/E as recently as last August as US-China tensions ratcheted up. However, since then, the Federal Reserve has cut interest rates further, and the market is indicating a high probability of another rate cut. Central banks around the globe have also aggressively cut rates, and long-term interest rates remain low, supporting valuations. Plus, in light of the coronavirus, China has indicated it will provide additional stimulus and add liquidity to help contain the economic fallout caused by the outbreak.
Another downside buffer for stocks is the lack of attractive alternatives. As a result of the pullback in stocks, alongside a sharp decline in interest rates over recent weeks, the percentage of S&P 500 stocks with dividend yields above that of the 10-year US Treasury yield has jumped to 64% from 47% at the end of December. This is well above the 30-year average of 18%. Thus, the relative attractiveness of stocks should help cushion the market’s downside, so long as a recession does not become the base case. We still view near-term US recession risks as relatively low. Importantly, stocks have risen on a one-year basis about 85% of the time outside of recession.
Outside of price levels, we are watching several indicators to signal that the market has become more oversold, or stretched to the downside, as well as gauges of investor fear. While we are not quite at wash out levels, fear is quickly creeping back into the market. This is a positive from a contrarian standpoint.

Bottom Line

While much uncertainty remains on the coronavirus, some of our near-term market concerns are starting to be alleviated as price, valuation and sentiment are reset. The risk/reward is beginning to improve. Our best estimate is that the market’s downside should be contained at about 5%-7% from current levels. However, what’s still missing is the time element. Thus, investors should be braced for wide swings in both directions in the days and weeks to follow.

We are still viewing the current action within the context of a bull market. We will continue to monitor the situation, and update any shifts to our base case, if necessary. Even though this pullback has been fierce, it’s not necessarily unusual following the sharp gains we had seen or in the context of this bull market. Such pullbacks, while always uncomfortable, are the admission price to the stock market and participating in the potential for higher returns over time.


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