After a week that killed the longest bull market in history and saw stocks post the biggest one-day plunge since the crash of 1987, investors are struggling to come up with clear-eyed assessments of the damage the COVID-19 outbreak will do to the economy, and what financial markets have already priced in.
Calls for a U.S. recession already appear to be the consensus view, noted analysts at Jefferies, in a Saturday note.
“While that doesn’t exactly mean that the jitters in the market are nearing a crescendo, the economic numbers have yet to come in, and it remains unclear for how long we will slow, the extent to which we slow (or contract) or how long it will take for those items to be priced into securities,” they said.
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But there’s no doubt that last week’s market carnage, forced liquidation and white-knuckle volatility across asset classes reflected a decidedly downbeat, if not worst-case, view. The speed of the stock-market selloff was breathtaking, with the Dow Jones Industrial Average and S&P 500 completing declines of more than 20% from February all-time highs – meeting the definition of a bear market – at the fastest pace on record.
Compared with previous stock-market corrections – pullbacks of at least 10% from recent peaks – over roughly the last century, the daily magnitude of the price changes has also been noteworthy (see table below),
Although around a third of the corrections over that time period have been deeper, “we have never seen an [S&P 500] correction move the way this one has,” they wrote. “As shown in the table above, corrections tend to take time. This has been the most rapid correction to date, with the average daily loss setting a new record by a wide margin.”
Is the selloff a case of investors ripping the bandage off quickly? The Jefferies analysts argued that the speed of the slide could “could bode well with regards to the speed of market recovery.”
Of course, for the stock market, the abiding question is what happens to earnings.
In a Saturday note, Michael Kramer of Mott Capital Management, said his model’s worst-case scenario forecasts no earnings growth for 2020, or roughly $158.60 a share for the S&P 500, roughly in line with 2019 earnings of $157.10. It forecasts growth of 11% in 2021 to $176 a share. Based on a price-to-earnings ratio of 16, the S&P 500 is worth roughly 2,850, he said, around 5.1% above Friday’s close at 2,711.20.
Kramer also ran scenarios that would see outright earnings contractions, which also suggested “relatively limited” downside for the index. Since 1988, modest recessions, such as the 2001 downturn, saw earnings fall by roughly 30%, he said, while periods of slowing growth that avoided contraction, such as in 2015 and 2016, saw earnings decline around 10%, he noted.
A scenario similar to 2015 and 2016, in which gross domestic product growth slows to around 1% to 1.5%, earnings could take a 10% hit from 2019 levels, he said, followed by a modest 10% rebound in 2021. With a P/E ratio of 16, that would put the value off the S&P 500 at around 2,520.
A 2001 scenario, which Kramer sees as the “worst-case” scenario, would see earnings collapse by 30% followed by a 20% 2021 rebound, for an S&P 500 value of roughly 2,130.
So what have investors priced in? The scope of the fall, which saw the S&P 500 27% below its peak at Thursday’s close, ahead of a Friday bounce, is right in line with selloffs seen around previous recessions, wrote Deutsche Bank strategists Parag Thatte, Srineel Jalagani and Binky Chadha, in a Friday note (see chart below).
At Thursday’s close, the S&P 500 was trading at a level that implied a fall in the Institute for Supply Management’s manufacturing index to 35% (a reading below 50% signals contraction) and a 25% fall in earnings, both of which are commensurate with a severe recession, they wrote.
Equity volatility, meanwhile, has been running at levels associated with history-defining events that occur once every several decades, they said (see chart below).
“For example, over the last 3 weeks we have seen the S&P 500 move more than 3% in either direction 10 times, a frequency previously seen only in the Great Financial Crisis and the Great Depression,” they wrote.
Volatility in other asset classes is also very elevated, especially in bonds and commodities and to a lesser extent in FX, they said, while a measure of cross asset volatility also hit extremes.
Volatility-related selling by systematic traders was blamed by many market participants for last week’s turmoil. The Deutsche Bank analysts estimated that leveraged funds significantly cut exposure as portfolio volatility rose, reducing positions across the board from both the long and short side of the market regardless of underlying momentum signals.
Cross-asset correlations flipped and even traditional safe havens, including gold and Treasurys, saw bouts of selling, putting additional pressure on equities in an environment where liquidity was already at record lows and raised stock-market volatility even further. What happens on the volatility front, meanwhile, will be crucial.
“As we have noted previously, a moderation in volatility is an important precondition for investors to raise risk exposures,” the Deutsche Bank analysts wrote.