Risk happens fast...
Last week, U.S. equity markets suffered their worst weekly decline since the dark days of the 2008 Financial Crisis, with the S&P 500 (SPY) dropping more than 11% in just five trading days. Perhaps more importantly, we set a new record in terms of the speed and severity of a drop from record highs reached two short weeks ago on February 13th. The violence of this move is best captured in the Volatility Index (VXX), which exploded from a complacent 14 in mid-February to as high as 50 on Friday:
While this violent correction caught many investors off-guard, the truth is that the warning signs were flashing bright red for weeks leading up to this event. In the Atlas Research Blog - where I track a live portfolio with real time trades - I've been writing about deteriorating technical and fundamental indicators for several weeks, including this warning issued on February 17th:
The bottom line: today's market dynamics are not the stuff of sustainable, healthy bull markets. Instead, all evidence points towards a terminal stage, blow-off top emerging in U.S. equity markets ... And given the speculative excess in today's market, things could turn ugly fast."
Followed by this warning issued on February 23rd:
Thus, the current economic and financial backdrop represents a bubble in search of a pin. And all signs indicate that the escalating Coronavirus outbreak could deliver the proverbial pin prick.
In today's article, I'll detail why U.S. stocks were vulnerable to slowing economic and earnings growth even before the Coronavirus outbreak. I'll also detail why the Coronavirus outbreak could already been a much bigger problem here in the U.S. than the "official" statistics suggest. Finally, I'll show why the recent price action indicates we're entering into a bear market, and why central banks won't save us from the coming declines in U.S. stock prices.
Let's start by analyzing the current economic fundamentals.
US Leading Indicators Slowing Before Coronavirus Outbreak
The post-World War 2 history of U.S. credit cycles shows that every credit boom eventually gives way to bust via the following sequence of events...
A tightening labor market pushes wages higher, which exerts downward pressure on corporate profits. Stalling profitability causes corporations to first stop investing and stop hiring... and then start firing. That means we can look at wages, job openings and business investment as leading indicators, whereas things like the unemployment rate represents a lagging indicator.
Starting with wage growth, U.S. average hourly earnings growth trended between roughly 2 - 2.6% annually since the start of the current economic recovery in 2010 through early 2018. But starting in May 2018, U.S. annual wage growth broke out to a new post-recession high of 2.9% before accelerating to a peak of 3.5% in February 2019.
This accelerating wage growth, which operates with a multi-month lag, started pressuring corporate profits in late 2018. The chart below shows how S&P 500 earnings per share began stalling in Q4 2018, and then started rolling over in Q3 2019:
Like clockwork, these stalling corporate profits sparked a persistent decline in business investment starting in Q1 2019, which has only accelerated downward over the last year:
Declining U.S. business investment translated into a similar decline in U.S. manufacturing order growth, starting in Q4 2018:
And despite the appearance of strength in the lagging indicator of the U.S. unemployment rate, the key leading indicator in the U.S. labor market - job openings - shows a persistent and accelerating trend of weakness starting in early 2019. Historically, job openings have correlated almost perfectly with both corporate earnings and stock prices. But as you can see in the chart below, a gaping chasm emerged between the accelerating weakness in job openings and the melt-up in stock prices since 2019:
I noted in a February 17th blog post:
Of course, you can look at this chart in one of two ways...
1) The downward trend in job openings is temporary, and will soon revert back up to stock prices
2) The upward trend in stock prices is temporary, and will soon revert back down to job openings
My bet is on option number two.
But it wasn't just the fundamentals leading me to this conclusion. Persistent declines in U.S. Treasury rates and strength in the gold market confirmed this emerging economic weakness, since late 2018:
In short, the S&P 500 (SPY) was the odd man out, rallying to record highs despite clear fundamental and technical factors pointing towards credit cycle exhaustion since late 2018. Meanwhile, the warning signs flashing in the U.S. have been mirrored by similar weakness among foreign economies. And just to reiterate, all of these key economic data points in the U.S. and abroad reflected economic conditions before the impact of Coronavirus outbreak.
Global Economic Data Deteriorating before Coronavirus Outbreak
Starting in Europe, the chart below shows that the Eurozone region posted a 4.1% decline in industrial production in December - the largest drop since the 2008 Financial Crisis:
And in mid-February, Japan printed a 6.3% decline in Q4 GDP - the sharpest decline in the last five years.
Other key economies across Asia also showed signs of a coordinated slowdown going into 2020, including Thailand recently registering its slowest economic growth in five years, and Singapore warning of a potential recession this year, according to a Reuters report:
"The downgrade of its (Singapore's) GDP forecast range to -0.5% to 1.5%, from 0.5% to 2.5% previously, opens up the possibility that full-year growth could be negative, with the prime minister saying on Friday that a recession is possible."
So these data points all indicate a coordinated economic slowdown across the U.S., Europe and Asia going into 2020. And then, of course, the Coronavirus (officially the COVID-19) outbreak hit, which threatens to further derail an already-weak global economy.
The Coronavirus: A True Black Swan Event Not Fully Priced into Stock Prices
As early as late January, it was quite clear that the emerging Coronavirus outbreak in China was a much bigger deal than "just another flu". Even though evidence suggested that the Coronavirus data coming out of China was likely flawed, you didn't even need to pay attention to the numbers being reported. Instead, you simply needed to observe the unprecedented quarantine actions the Chinese government was taking in response to the outbreak, as I explained on January 26th:
Just look at the actions China is taking in setting up quarantines for over a dozen major cities, spanning more than 50 million people. Their response alone indicates the severity of this situation.
But even despite reports from the New York Times that China had at least partially locked down "at least 760 million people" as part of an unprecedented quarantine effort, countless media outlets promoted the flawed narrative that we were simply dealing with a temporary blip that investors "shouldn't worry about".
Of course, after last week's 12% drop in the S&P 500, investors are now starting to price in the Black Swan nature of the Coronavirus... but I think the repricing is only just getting started. And you don't need a PhD in virology to appreciate the kind of risk that looms on the horizon. In fact, you only need to understand two simple variables: the rate of the Coronavirus transmission and the hospitalization rate for those who get infected.
Starting with transmission, virologists use R0 as the key metric that determines how many people, on average, will transmit a contagious disease. For example, an R0 of three means that each infected person will pass the virus on to an average of three additional people.
The CDC estimates that the common flu sports an R0 of roughly 1.3. That's enough to infect roughly 8% of the entire U.S. population each year, including 32 million people during the current flu season. And while we don't have as much empirical data to determine the Coronavirus R0 with certainty, current estimates in the medical literature suggests a range of 1.4 - 6.49, with an average of 3.28 and a median of 2.79.
Thus, assuming an R0 of 2.5 - a conservative estimate at the lower end of the estimated range - the Coronavirus is about twice as contagious as the common flu. Now the key point here is that viral infections spread exponentially, not linearly. So an R0 twice as large as that of the common flu means the Coronavirus could theoretically infect much more than twice as many people as the flu. Some experts have recently warned that up to two-thirds of the world's population could be at risk of contracting the Coronavirus.
Now I realize that sounds alarmist... but let's conservatively assume a more mild scenario of a roughly 10% infection rate - only slightly higher than the common flu. That would still present a catastrophic scenario. Why? It's all about the second critical variable in this Coronavirus outbreak: the hospitalization rate.
Experts like Dr. Antony Fauci - the head of the U.S. National Institute of Allergy and Infectious Diseases- estimate that roughly 15 - 20% of people infected with the Coronavirus will require hospitalization. That includes things like supplementary oxygen and/or respirators, plus advanced quarantine requirements to keep the highly-contagious virus from spreading to medical workers and other hospital patients.
So let's run through the basic math of a hypothetical 10% infection rate in a place like New York City (NYC), which translates into 850,000 infections out of a population of about 8.5 million. Assuming 15% of total infections require hospitalization means a sudden spike in demand for 127,500 hospital beds.
Now, let's compare this hypothetical need for 127,500 hospital beds with a recent statement from NYC Mayor Bill de Blasio, who recently claimed that NYC is "prepared for a Coronavirus outbreak with 1,200 hospital beds." See the problem here? Given the 15% estimated hospitalization rate for Coronavirus infections, Bill de Blasio is implicitly assuming that NYC will suffer no more than 8,000 total Coronavirus cases at any one point in time. Color me extremely skeptical of that assumption.
The bottom line: it's not necessarily the mortality rate of the Coronavirus that presents the biggest problem (although at an estimated 3.4% mortality rate, that's still a BIG problem) - it's the potential for the virus to completely overrun our medical system.
And this isn't just speculation, we've already seen what happened in Wuhan, China - the epicenter of the outbreak - when soaring infection rates overwhelmed the city's hospital system. Not only did thousands of Coronavirus cases go untreated, but exhausted resources forced hospitals to turn away patients for other critical services, like dialysis treatment, according to Time Magazine:
A woman who answered the (Wuhan) hospital's hotline said it can't admit dialysis patients at the moment because the hospital has been taken over for coronavirus treatment.
We're seeing similar exhaustion of medical resources in Daegu, South Korea - the location of the largest Coronavirus outbreak outside of China. Meanwhile, the Coronavirus outbreak doesn't just threaten to exhaust hospital beds and medical workers, but we could see shortages of critical pharmaceutical products from supply chain disruptions from the Coronavirus outbreak. We're already seeing early signs of this, including the following Bloomberg report from March 3rd:
India, the world's largest maker of generic drugs, restricted on Tuesday the exports of certain common medicines and 25 active pharmaceutical ingredients, as it looked to prevent shortages amid concerns of the coronavirus outbreak turning into a pandemic.
In short, the Coronavirus threat of not only slower global growth, but major disruptions in critical supply chains, reflects a true black swan emerging in today's economic and financial landscape. Should we see a major breakdown in the global trade for critical medical equipment and pharmaceuticals, there's simply no telling how extreme this situation can become.
But as bad as this all sounds, I believe that the Coronavirus outbreak is ultimately a problem that can be solved with strong enough quarantine efforts. However, from an economic standpoint, quarantines mean one thing: a collapse in growth. Again, this isn't just speculation - we already see this showing up in the data of the countries pursuing the most aggressive quarantine procedures, including China, Hong Kong and Singapore.
Asian Economies Buckle Under Quarantine
Starting with the epicenter of the CoV outbreak in China, the country's unprecedented containment efforts have resulted in total or partial quarantine lock-downs for "at least 760 million people" according to the New York Times. That's roughly half of the Chinese population, and it's showing up in a variety of economic indicators, including the sharpest decline in the country's factory activity on record:
Similar containment efforts due to the outbreak in Hong Kong have resulted in a collapse in the country's purchasing manager's index (PMI) - a key leading indicator of economic output that correlates closely with future GDP growth:
Source: IHS Markit
Meanwhile, Singapore's aggressive response to the Coronavirus outbreak can be seen in a collapse in the country's transport of air cargo:
Make no mistake, this collapse in Asian economic activity will undoubtedly reverberate through the global economy. Goldman Sachs analyst David Kostin recently explained why he expects the decline in Chinese economic growth and supply chain disruptions will translate into zero earnings growth for the S&P 500 in 2020:
Our reduced forecasts reflect the severe decline in Chinese economic activity in 1Q, lower end-demand for U.S. exporters, supply chain disruption, a slowdown in U.S. economic activity, and elevated uncertainty.
Importantly, this note was published in late February, before we started to see accelerated spread of the Coronavirus throughout both Europe and in the U.S. So here's the trillion dollar question... what happens if (or when) we start seeing thousands of cases pop up throughout Europe and the U.S.?
U.S. Coronavirus Outbreak Likely Understated for Lack of Testing
The truth is, it's very possible that we already have a substantial and under-appreciated outbreak of the Coronavirus here in the U.S. that has so far gone undetected. The New York Times reports...
The Centers for Disease Control and Prevention botched its first attempt to mass produce a diagnostic test kit... A promised replacement took several weeks, and still did not permit state and local laboratories to make final diagnoses.
Due to the flaw in the original CDC test design, and restrictions placed on allowing state and local labs to perform their own tests, the CDC had tested less than 500 Americans for Coronavirus as recently as last week. This compares to other countries, like South Korea, who is currently running 10,000 tests per day.
So as of the evening of March 5th, the latest "official" U.S. numbers show 197 cases and 12 deaths... but due to the lack of testing, these numbers are likely vastly understated. Consider the fact that 12 Coronavirus deaths have so far been recorded in the U.S. If we use the WHO's estimate of a 3.4% mortality rate, that implies a total U.S. case count of about 353. But here's the thing... the Coronavirus takes an estimated 7 days to show symptoms, and at least another 7 days for those symptoms to progress towards a fatality.
That means the 12 deaths recorded as of March 5th translates into 353 cases two weeks ago. And considering the rapid spread potential of this virus due to its high rate of transmission, we could already be contending with over 1,000 cases in the U.S. today. Indeed, a study recently published by computational biologist Trevor Bedford suggests the potential for 500 - 600 cases in the Seattle area alone.
The bottom line: in the days and weeks ahead, as more and more testing capacity comes online, investors must grapple with the very real possibility of news crossing the wires showing a substantial outbreak already emerging here in the U.S.
So here's another trillion dollar question: what happens to corporate earnings and economic growth in a scenario of strict quarantine measures applied domestically to contain a Coronavirus outbreak in the U.S.? Already, some policy-makers and pundits, like former FDA Commissioner Dr. Scott Gottlieb, are advocating for "tough measures to mitigate local outbreaks", including things like getting Seattle to "shut down their economy for good of nation", as seen in the following March 5th Twitter post:
These "tough measures" could present a big problem for a U.S. stock market already trading at extremely rich valuations, in a scenario where both earnings and multiples contract.
U.S. Stocks Vulnerable to Earnings and Multiple Compression
I showed earlier how economic growth and S&P 500 earnings were already starting to rollover in 2019, even before the Coronavirus outbreak. The table below shows a list of standard valuation metrics for the S&P 500 index as of January 31st, 2020. Why this date? Because these numbers are based on sales, earnings, GPD and book values before any major economic distress from a potential Coronavirus outbreak. I plotted each number compared to its percentile rank throughout history, where 100% represents record high valuations and 0% record low:
Source: Bloomberg, Author Calculations
And given the growing use of earnings and EBITDA "adjustments" distorting true economic reality, many of the metrics cited above could be even more inflated that what shows up on the surface. That's why my favorite metric valuation metric these days is the price-to-sales ratio (given the greater difficulty in manipulating sales vs earnings). Using this measure, the S&P 500 was the most overvalued in history as of January 31st, 2020 (the last data point on this monthly chart):
In other words, going into February, stocks were priced for perfection - at or within spitting distance of record valuations across a number of key valuation metrics. Meanwhile, what if sales/earnings fall precipitously from here, given the economic disruption from the Coronavirus and/or a garden variety recession? In that case, the S&P 500 could actually be more overvalued today versus January 31st, even despite the recent 10% decline in prices.
Finally, if we go into an environment of declining sales/earnings growth, history shows that investors less likely be less willing to pay a high valuation premium for equities. And it's precisely this compression of both sales/earnings and valuation multiples that can make bear markets so devastating.
Going forward, even a modest recession could generate a 25% drop in S&P 500 earnings. When combined with a 25% compression in the earnings multiple, it's easy to see a scenario where the S&P 500 could decline by 50% or more from its recent record highs.
Central Banks Can't Stop the Coming Bear Market
Meanwhile, investors counting on central banks to prop up asset prices could be in for a rude awakening. History shows that, despite inspiring a series of illusory short-term rallies, cutting interest rates from 6.5% to a then-record low 1.5% did nothing to stem the 50% decline in the S&P 500 during the Dot Com collapse:
The same pattern played out during the 50% decline in the S&P 500 during the 2008 Financial Crisis, with every rate cut and stimulus-inspired rally only setting the stage for new lows:
Keep this historical perspective in mind when you start seeing headlines like this cross the wires:
Indeed, the very fact that stocks are starting to rally 5% or more on any given trading day is a warning sign in itself. Historically, bear markets produce both bigger and more frequent large gains than bull markets. You can see this in the table below, which shows the largest daily gains in the S&P 500 ETF (SPY) since its inception date in 1993 were generated during bear markets. The table also shows that bear markets produce a much higher frequency of daily gains exceeding 3% in the S&P 500 versus bull markets:
Source: Author Calculations
Thus, the huge daily swings we've been seeing since late February - both up and down - are simply one more indicator that we're now likely entering into a period of persistently elevated volatility and a prolonged bear market in stocks.
Going forward, I fully expect central banks to use aggressive monetary easing in a futile attempt at re-inflating asset prices. But unless the monetary authorities can conjure a Coronavirus cure from their printing presses, and/or reignite the global economic expansion, my bet is that it will pay to fade any monetary-inspired stock market sugar highs in the months ahead.
Finally, those interested in how I'm expressing these and other market views in a live portfolio can follow along here at the Atlas Research blog series.