COVID-19: The Black Swan
Summary
- Last week was the fifth-worst week in the history of the US stock market and all three major US indices declined more than 10%.
- The Coronavirus (COVID-19) could be the black swan, that has devastating effects on the global economy.
- First numbers like the Official NBS Manufacturing PMI in China show how extreme the impact on the Chinese economy was.
- Looking for a helping hand in the market? Members of Moats & Long-Term Investing get exclusive ideas and guidance to navigate any climate. Get started today »
We often tend to use superlatives. In my articles, I also use words like “rally” or “crash” quite often. But when talking about last week, superlatives seem to be appropriate as it was not only a week that might go down in stock market history, but also one of the worst weeks for the global stock markets ever. With the Dow Jones Industrial Average (DIA) losing about 3,500 points during the week (intraday it was even more than 4,000) it was the worst week for the US stock market since the financial crisis in 2008. Only in the final trading hour on Friday another day with a drop of more than 1,000 points was avoided, but for the week, the Dow Jones Industrial Average declined more than 12%, the S&P 500 (SPY) lost about 11.5% and the Nasdaq-100 (QQQ) ended the week about 10.5% lower. The two-year treasury yield declined 25 basis points to 0.86%, which is the largest one-day decline since the global financial crisis.
One might say, the bear return, but another animal and symbolic figure seems to be more appropriate: Out of the dark shadows, the black swan reveled itself and flapped its wings.
(Source: Pixabay)
The Black Swan
At this point, it makes sense to speculate if COVID-19 might be the infamous black swan, that can shock stock markets and bring economies to its knees. The concept of the black swan was made popular by the philosopher and essayist Nassim Nicholas Taleb and there are three criteria, that have to be met:
- The event has to be a surprise to the observer
- The event has to have a major (negative) effect
- After the first recorded instance of the event, it has to be rationalized in hindsight, as it could have been expected
Right now, we don’t know yet if the event will be rationalized in hindsight, but the first two aspects are definitely fulfilled. COVID-19 was a big surprise to observers as before December 2019 nobody could have known about the particular virus we are faced with right now. A pandemic was definitely not among the listed threats for the world economy during the last few quarters. And yet, COVID-19 has the potential to affect the global economy in a very negative way.
Of course, we all know that an epidemic or pandemic is possible. We know examples from the past like the Spanish Flu (the 1918 influenza pandemic), which might have killed as much as 50 million people or the Black Death, which might have killed 75 million to 200 million people in the years between 1347 and 1351 and eliminated one-third of the European population. We know that such events are possible, but we see them as such extreme outliers and tend to assume they will not happen. And therefore, we were talking about trade wars, about the bull market being in its last stages or who might win the 2020 election, but we haven’t talked about a global pandemic and entire cities and regions being shut down. We know that events like a pandemic could happen, but we tend to ignore that possibility (as the occurrence is highly unlikely).
COVID-19: January and February
The coronavirus (or COVID-19) is not really news at this point. It was identified in Wuhan back in December 2019 and on December 31, 2019, it was reported to the WHO as several cases were registered. But it took until mid-January before the story got picked up as major topic by the mass media in Europe and the United States. In a first reaction, the global stock exchanges (in the United States or Europe) declined a few percentage points, but could recover quickly and marked again new all times highs (not only the three major US indices, but also the German DAX-30 index for example).
And already several weeks ago, it became obvious that COVID-19 will be worse than SARS in 2002/2003 (to which it is often compared) with a higher number of absolute deaths and a higher number of identified cases. And with the world economy being much more interconnected than 17 years ago and China playing a much bigger role in the global economy, it seemed pretty obvious that the negative effects might be worse. But during these weeks, market participants did not care about these facts.
COVID-19: The Past Week
But during the last week something changed. To be more precise: on the previous weekend (February 22 and February 23) something changed. The simple keyword might be – pandemic. During the previous weekend, there were strong hints, that COVID-19 might not just be a big problem for China, but also for many other countries all over the world and that COVID-19 could become a pandemic after all. Last Monday, the WHO still refused to call it a pandemic and only called it an epidemic, that is spreading in different parts of the world.
The three countries that shocked the world and the financial markets were South Korea, Italy and Iran. In my opinion, especially the situation in Italy was the trigger for the stock market declines. The rapid rising number of confirmed cases in Italy, a country which is thousands of miles away from China, was frightening news. And we are already looking at almost 1,700 confirmed cases in Italy and 34 deaths. But also, Iran with 978 confirmed cases and 54 confirmed deaths seems to be problematic. And aside from Mainland China, South Korea has the highest number of confirmed cases (3,526) and although the number of deaths is rather low (only 17), this is a shock for the markets.
(Source: Johns Hopkins CSSE)
Global Economy Balancing on a Knife’s Edge
The problem is that COVID-19 is hitting a stock market that is extremely overvalued and an economy that is already weakening. COVID-19 might be the trigger, but maybe not the only reason for the extreme decline. I claimed several times in the past two years that we are close to a market top and that the market is overvalued. But the market continued to mock me by climbing higher and higher. In my opinion, the global economy is balancing on a knife’s edge for several quarters now and COVID-19 might have sounded the death knell for the global economy and a global recession could be inevitable. And maybe analysts and market participants realized in the last few days that a potential pandemic is more than the global economy can withstand right now.
During the last year, the global economy was already tested several times. With the bull market and global expansion lasting for more than 10 years, the growth was already slowing down and the trade war was another severe test – not only for the Chinese and US economy. Executives stopped investing in some cases or delayed the hiring of new people and the high levels of uncertainty were already problematic.
When trying to determine if the stock market is overvalued, the CAPE ratio is still one of the most reliable measures.
(Source: Advisor Perspectives)
And while the S&P 500 rushed from new all-time high to all-time high, the earnings per share of the S&P 500 are not reflecting that optimism so far. According to Multpl.com, the inflation-adjusted 12-month real earnings per share are already declining – not much, but in the low single-digits. The last number is from September 2019, but I don’t think it got better in the meantime. And of course, any potential consequences from the coronavirus are not reflected in these numbers yet.
The Fed also reacted last year to the economic slowdown and lowered rates three times in 2019. And we already saw an inverted yield curve in the past and constantly lower treasury yields. Especially in the last week, the treasury yields dropped to levels we haven’t seen for quite some time.
(Source: Own work based on numbers from U.S. Department of the Treasury)
The purchasing manager index in the United States was already indicating trouble. And although the numbers for January 2020 showed some improvement and catapulted the number again above 50, we see a clear decline in the last year.
(Source: Trading Economics)
And while the job market is still in a healthy condition, the year-over-year growth of employees also slowed down in the last few years.
(Source: FRED)
These are all numbers for the United States, which are still in a very healthy condition. Other countries – like many European countries – are already showing more signs of trouble. COVID-19 is therefore hitting a global economy that is already showing several signs of weakness and might not be strong enough to withstand this challenge (a potential pandemic).
Economic Consequences
We don’t know right now how hard COVID-19 will hit the economy, but we get first glimpses, what the consequences could be. And it is not only fear and uncertainty hitting an already weaker economy.
Several companies already issued guidance warnings in the last few days and weeks – among those such prominent companies like Mastercard (MA), which is expecting lower revenue due to lowered consumer spending or Apple (AAPL), which expects lower revenue due to iPhone supply shortages and lower demand, especially in China. CNBC reported, that United Airlines (UAL) is offering pilots a month off due to flight cuts, Deutsche Lufthansa (OTCQX:DLAKF) announced it will cut costs where it is possible, hotels are already forcing their staff to reduce working hours and it is not surprising that people are afraid to travel and go on vacation. Indonesia, for example, tries to attract about 10 million tourists from China per year and it is expected that Indonesia might lose about $4 billion in tourism-related revenue as a result of COVID-19. And of course, this has further consequences like thousands of Chinese-speaking tour guides already having lost their jobs in Indonesia. But not only tourism and vacation are among the sectors hit hard. People also stopped purchasing other goods and items. Car sales in China, for example, declined about 20.5% in January, which is reflecting the largest monthly dip in 15 years. And for the first two weeks of February, sales declined 92% as many showrooms in Mainland China were closed.
A few days ago, the Jibun Bank Japan Manufacturing Purchasing Managers’ Index dropped to 47.6 from 48.8 in the previous month and was clearly below market expectations (49.0). This number is not only indicating a recession, but is also the lowest number in more than seven years.
(Source: Trading Economics)
A real shock – and maybe the clearest indication how hard the Chinese economy was hit – was the Official NBS Manufacturing PMI in China, which plunged to 35.7 in February 2020 from 50.0 in January 2020. The clear miss of market expectations (which was 46.0) is not only indicating that market participants are still underestimating the economic consequences. The number is also the lowest reading ever (since the number was first released in 2005) and even lower than the low point of 38.8 during the Financial Crisis.
(Source: Trading Economics)
We can now hope that this is just an isolated number and everything will be fine in the next few months again. And if China can go back to normal within the next few weeks, these horrible numbers might have been anomalies. But the risk that this is just the start of a vicious cycle is extremely high. The lock-down of several weeks might have consequences, we can only guess right now. Thousands or millions of small or mid-sized businesses in China might run into huge problems as the missing revenue of several weeks is more than these businesses can withstand and they might declare bankruptcy. Small companies often don’t have the financial resources to pay for the fixed costs for one month or longer without any revenue. This might lead to defaults, which could lead to troubles for smaller banks and as these small companies might be the supplier for larger corporations, they could face troubles as well. Many companies in China are suppliers for other companies in Europe and the United States. And the companies that are dependent on the suppliers will also face problems in the coming weeks. Finally, other countries could face similar lockdown scenarios like China. In case of Italy, the affected regions are in the north of Italy, which is the economic engine of the country and the economic consequence could also be severe – depending on how long the lockdown will last.
A Didactic Play
I really don’t know what will happen in the next few weeks and how severe the consequences will be. I also don’t know if COVID-19 will become a global pandemic or if a global recession is now coming. But what happened in the last few weeks is a didactic play and especially the last week could become one for the history books as it demonstrates how fast the situation can change. The black swan should be a warning symbol that we never can control the situation and should always be prepared. No matter how experienced an investor is and how much data we have about the market and the economy, some events can’t be foreseen and some situations can’t be controlled.
The last week is a great example how quickly the situation can change completely and how difficult it can be to react adequately to such a dramatic shift. I am basically expecting the market to top for about two years now, but also didn’t expect the stock market to decline at this point, to decline so sudden and with the extreme selling pressure we saw last week. Until 10 days ago, we saw extreme confidence, that the stock market will continue to climb from high to high and that tweets from Donald Trump or the Fed lowering rates will fix everything. The past few days demonstrated that overconfidence can be a huge mistake and on Monday, I read several times that the dip (at that point a 2-3% decline) is a great buying opportunity as a larger correction seemed unlikely. Well, it wasn’t a great buying opportunity. And now, on Sunday afternoon as I am writing this, it is difficult to say if current stock prices are a good buying opportunity.
Conclusion
In his book “The black swan,” Taleb tells the following story:
Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly member of the human race ‘looking out for its best interests’ as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief. (The black swan, p. 40)
February 23, 2020, was the day before Thanksgiving in our case and all the knowledge we had from the past (The Fed stabilizing the economy, Trump tweeting and lifting stock prices) was worthless and turned out to be wrong.
I am writing these lines about three hours before the futures will start trading and I am expecting that the horrible China PMI numbers will shock the markets again, but I assume that the correction will come to an end in the next few days. And stock prices might stabilize again in the next few weeks, but I doubt this is a medium-term or long-term buying opportunity.
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