Insight

Is Resistance Futile?

KCS Wealth (Byline: Ken Waltzer)

March 3, 2020

This is a long newsletter, with lots of information. For those who want just the highlights, here they are:

• Stocks fell sharply last week on coronavirus fears.
• We think this is a correction, not a bear market, meaning stocks should regain their footing in the next several weeks.
• This is not the time to make major changes in your portfolio and you should never try to “time” the market.
• That being said, if you have excess cash, this might be a good time to consider deploying it.
• The greater volatility of stocks vs. “safer” investments is the price one pays for their higher returns.
• The coronavirus spread is likely to continue and cause significant global economic disruption, particularly to the global supply chain, but will also affect demand in some areas.
• We think this disruption will be short lived ( 2 to 4 months) and not lead to a recession.
• The new coronavirus (COVID-19) has similarities to influenza, a disease that kills half a million people each year, but also important differences. One is that COVID-19 is a new and unknown disease, making it more frightening than the more familiar “flu.”
• You should prepare for coronavirus by practicing the same preventive techniques you would use for any virus, including frequent handwashing.

A typical—but super-fast—correction

What a week! Unless you live in a cave, you know that the last week of February was a wild week in the markets—and not in a good way. From the close on Friday, Feb. 21 through the following Friday, the S&P 500 index plunged –11.5%, its biggest drop since October 2008 during the midst of the financial crisis. As of the market close on Friday, Feb. 28, the index was down –12.8% from its Feb. 19 high. Intra-day on Friday, the S&P 500’s total decline from high to low came to –15.8%. (Obviously, the big surge on the first trading day of March has already further mitigated the decline.)

In the context of past corrections, the current drop in the market indexes has been decidedly average (historically, the mean decline for a correction is –13.8%). What was unusual was the speed of the drop, as most corrections take about 3 weeks from peak to trough. Please realize that this does not mean that we have 2 more weeks of declines ahead of us, as there are a number of technical reasons to believe that the low for the correction (and likely the year) was set on Friday, at 2,856 on the S&P 500. These include the historical patterns of past corrections, the level of the VIX or “fear gauge” reached on Friday, and the decline occurring at the end of a month.

Although a rebound in the near term is likely [ed. note: we wrote that before this Monday’s surge], stocks will almost certainly struggle to regain their previous highs over the next several weeks as the markets follow the progress of the new coronavirus closely. It’s also possible that we’ll see another down leg (perhaps after re-testing Friday’s lows) after an initial recovery before the market finally regains its footing. When corrections have 2 or 3 bottoms, they are typically each 4 weeks apart. That would put the ultimate recovery around 6 to 10 weeks out. Obviously, this “schedule” is subject to change as a result of unexpected developments, both negative and positive. We can probably all think up examples of the former (e.g., spread of coronavirus throughout the US). Examples of the latter include an unexpected Fed rate cut and development of an effective treatment.

Don’t try to time—or game—this market

How should investors respond? Certainly not by selling stocks now that the market has fallen sharply, even if there might be some more declines ahead. Try not to let fear take hold, and prepare yourself for an ugly February account statement. Realize that February 28 is just one point in time and not a good measure of your net worth or the earning power of your portfolio.

And don’t try to time the market. Even though corrections tend to follow the pattern described above, there are too many unknowns to bank on this one being true to form. The best bet, as always, is to stick to your investment plan, and don’t even think about changing it while the markets are in the midst of so much volatility. Addressing your long-term goals should ideally come during times of relative calm so that you aren’t influenced by current events.

If you have extra cash that you have been waiting to deploy, now might be a good time to do so. You could invest it all at once or spread it out over 2 or 3 months to take advantage of likely ups and downs in the market over the near term. But don’t overinvest in stocks just because they seem cheap relative to a week ago—target the same long-term allocation you should have already decided upon.

What will KCS be doing over the next few weeks? As you might imagine based on what we wrote above, we are not changing overall investor allocations. However, relative values have changed significantly in a few days’ time and we are likely to be tweaking portfolios to take advantage of this. There is also likely to be some tax loss harvesting that we can take in recently purchased securities that are now below their acquisition cost. Tax loss harvesting takes advantage of the fact that, in a diversified portfolio, not all securities move in tandem. Even in an up market there are securities that are down (and vice versa). By taking available losses and reinvesting in similar securities, we can reduce capital gains taxes in our client accounts.

The stock market always recovers—it’s only a matter of when

At this point, a dramatic comeback in stock prices may seem like a pipe dream. But did you think, back on Christmas Eve 2018, when the S&P 500 was down –20% from its October high, that it would rise +43.8% over the following 14 months? We’re only 2 weeks from that Valentine’s Day peak, though it might already seem like a lifetime ago. Markets can turn on a dime, in both directions. Don’t count this one out because of one bad (OK, horrendous) week.

As we have pointed out several times in the past, periodic scary volatility, specifically sharp declines like those we saw last week, are the price investors pay to enjoy the higher long-term returns of equities vs. “safer” investments. While government bonds, for example, are typically far less volatile than equities, the latter have returned far more over time. Depending on the period chosen, the average annual return for the S&P 500 index has been between +8.6% (since 2007, including the financial crisis) and +9.8% (since 1928). But these returns come in waves, with some years being up a lot and some down, and very few (only 6 of the past 90) coming in between +5% and +10%. 10-year US Treasuries, on the other hand, are yielding 1.13% as of Friday. Stocks have more volatility, but you do get paid handsomely to put up with it.

Remember that because of their higher volatility relative to bonds and cash, and also because their positive returns tend to come in spurts, stocks are long-term investments. This means that you should not invest funds in stocks that you may need in the short term (meaning less than a few years). Stocks can, however, be quite appropriate for money that you are drawing down gradually over time, such as in retirement. The key is what is the right exposure to stocks for you based on your particular needs, not on the near-term behavior of the markets.

How will coronavirus impact the global economy?

Now on to coronavirus, specifically the COVID-19 strain now making its way around the world. We assume you’re interested in 2 main issues: how will it affect the economy and how will it affect my health? We’ll deal with the economy first.

In our previous eNewsletter a week ago, we discussed the impact of the virus on the global supply chain, particularly in China and South Korea. If the virus continues to spread around the world, other supply chain disruptions are possible. What this means is that the manufacture and shipment of many products could be delayed for lack of parts; this includes everything from cars to TVs to iPhones. Obviously, shortages of products will inevitably lead to an economic slowdown, as even if there is demand, there aren’t enough goods to go around.

On the demand side, industries that will be hardest hit include travel and tourism—airlines, hotels, cruise lines, convention centers, sports arenas, etc. Also hit will be industries related to events and conventions, including related businesses such as restaurants and souvenir shops. We are already seeing quite a bit of this around the world. China may provide the best model for what might happen if COVID-19 were to spread widely in another country. The slowdown began there on February 8, right after the conclusion of the Chinese New Year. While we won’t have GDP data for another few weeks, we do have the manufacturing and service PMIs (Purchasing Manager Indexes) from February. These surveys are designed to provide a semi-quantitative measure of business activity by interviewing individuals who purchase goods and services on behalf of private companies.

The data from China were not pretty, as you might imagine. In fact, they were considerably worse than forecasters expected. On a scale where 50 represents no change, with numbers above signaling growth and those below contraction, the manufacturing PMI came in at a record low of 38.8, while the services PMI was 29.6, also a record low. These numbers show fairly convincingly that economic activity in China slowed dramatically during February.

How long will the economic downturn last?

The good news is that as March opens, people are going back to work in China. As of last week, the government says that over 70% of production in the major manufacturing and export hubs had resumed. The majority of smaller companies, however, are still shut down owing to difficulty finding workers and parts, but this is also starting to abate. Last week, Apple reopened half its stores in China, and 3 days ago Starbucks announced that it had reopened 85% of its stores. In short, China is starting to go back to work, though it will probably be April before the majority of the economy is running normally.

Given that China was the hardest hit by COVID-19, and is likely to remain so, the worst-case appears to be 5 to 7 weeks of sharp drops in economic activity followed by a rebound. Whether any other country fares as poorly as China remains to be seen, but this so far seems unlikely.

Could COVID-19 lead to a recession in any of the affected countries, including the US? This is not our base case, as the global impact is likely to be shorter than 2 quarters (the duration of contraction needed to define a recession) even in the hardest-hit countries. If there were an actual recession, it would almost certainly be on the mild side, nothing like what we saw in 2007–2009.

Keep in mind that mild recessions (such as those in 1980 and 1990) lead to rather modest stock market losses. In 1980, the Fed tightened monetary policy to combat inflation, and the S&P 500 lost 20% of its value over a 6-week period; it had fully recovered 3 months later. In 1990, a recession occurred in the wake of the savings and loan crisis. That time, the decline in the S&P 500 was also –20%, but the duration was longer, around 6 months from initial peak to full recovery. Note that –20% is not much more than the –15.8% we already last week’s decline.

In short, the economic impact of the COVID-19 virus on the global economy, including the US, could be very significant if we or other countries experience the type of spread that China has seen. But even if this were to occur, we believe that any downturn is likely to be short lived and the economic and financial rebound strong and brisk.

What about the health impact of COVID-19? How bad is it?

Many have compared COVID-19 to the influenza virus, which has been with humans for millennia. “Flu” is not an illness to take lightly. Despite the availability of a vaccine which is about 70% effective and 4 FDA-approved medications that work over 99% of the time, more than 500 million people catch the flu each year, 5 million suffer a severe case and about 650,000 die. You read that right: worldwide there are over half a million deaths each year from seasonal influenza. During the current 2019–2020 flu season, the CDC estimates that the US has seen 32 million flu illnesses, 310,000 hospitalizations and 18,000 deaths. (During the 2017–2018 flu season, the US saw a record 80,000 deaths.) Here’s a comparison of this year’s flu season with COVID-19: https://jamanetwork.com/journals/jama/fullarticle/2762386.

The overall case fatality rate (the percentage of people with the disease who die) for influenza in the US is about 0.1% or 1 in 1000, but higher in many developing countries. We don’t yet know the true rate for COVID-19, in large part because we don’t yet have a good estimate of how many people have contracted the illness. As with influenza, many cases are mild or even asymptomatic and never come to medical attention. The best data we have come from 2 recent studies in China, which found case fatality rates ranging from 1.4% to 2.3%. As we identify more cases and can better estimate the total number, it seems likely that the case fatality rate will fall, perhaps to below 1%. While this is significantly higher than most seasonal strains of influenza, pandemic influenza strains have had case fatality rates of 0.6% (1957) and even 2% (1918.) Yet all of these are far lower than the case fatality rates for 2 other coronaviruses: SARS at 9.3% and MERS at a whopping 34.4%.

As with influenza, the majority of deaths from COVID-19 are in the elderly and those with underlying disease. Children are much less likely to die, and there has not been a single death from COVID-19 in children under age 10. (Influenza, meanwhile, has killed 125 children in the US so far this season.) So far, the two most important differences between influenza and COVID-19 are the higher case fatality rate and rate of transmission in COVID-19. To calculate transmission rates, epidemiologists measure the R0, or the number of other people that one disease carrier is likely to infect. For influenza, the number is 1.3, while for COVID-19 it appears to be around 2.3.

In sum, COVID-19 is both more contagious and more deadly than influenza. For this reason, it’s important to global health that the current epidemic doesn’t spiral out of control. So far, the numbers are incredibly small relative to influenza. And the current declining rate of infection in China suggests that even when serious mistakes are made early on, it is possible to gain control of this outbreak.

There are no guarantees, but it seems unlikely that COVID-19 will evolve to anywhere near the scale of a seasonal influenza outbreak. The are several reasons to believe this. For starters, major public health control measures are being put in place to reduce the spread of COVID-19, whereas for influenza, there are no such controls other than a vaccine that is far from universally deployed. Also, despite its relatively higher contagiousness, COVID-19 is a brand-new human virus, whereas flu has been with us for thousands of years and is well established in the population. Thirdly, awareness among individuals regarding COVID-19 is very high, leading to far better infection hygiene than we see during a typical flu season.

If COVID-19 were to spread as widely as influenza, the number of global deaths could be quite high, perhaps in the millions. At that point, the impact would be far more severe than we are predicting. However, the experience in China plus ongoing containment actions suggests that this is an extremely low-probability outcome.

Given the dramatic difference in the numbers, why is COVID-19 so frightening compared with influenza, an illness that kills hundreds of thousand each year? Why, in fact, do people not fear automobiles, which kill 1.25 million people per year and injure over 20 million? The answer, of course, is familiarity. Cars and the flu are dangers we know; COVID-19 is an unknown. The unknown is always far more worrying than the known, no matter how dangerous the known might be.

Be smart—protect yourself from coronavirus (and other infections)

How to deal with the unknown? Take action. Here are ways you can protect yourself from COVID-19, should it enter your community. These techniques work, of course, for all infectious diseases, including influenza. If more people practiced them, we’d have a lot fewer illnesses and deaths each year.

1. Wash your hands frequently—and well. Use a generous amount of soap and scrub for 20 seconds and dry them well. Here’s more detail on how to do it right: https://www.cnn.com/2020/02/28/health/how-to-wash-hands-coronavirus-trnd/index.html. You can also use hand sanitizer in between washings.
2. Avoid touching your eyes, nose and mouth.
3. Disinfect surfaces that are touched by multiple people, such as doorknobs, refrigerator handles, telephones, etc. Use a hand sanitizer or disinfectant that contains at least 60% alcohol.
4. Be especially wary of very public surfaces, such as the aisle-side armrest on airplanes.
5. Stay at least 6 feet away from people who are actively coughing and/or sneezing.
6. Surgical face masks are essentially useless to protect against infection. For this purpose, you’ll need an N95 respirator, which is quite uncomfortable and only recommended for healthcare professionals. On the other hand, if you are ill and coughing or sneezing, a regular face mask can help protect others from catching your illness and has the bonus of reminding them to keep their distance.
7. Cough into your elbow or a tissue (that you immediately throw away).
8.  If you are ill with a cough, especially if you have a fever as well, STAY HOME. If you have any reason to believe that you came into contact with COVID-19, contact a doctor to report the illness and be tested.

For more information on protective measures, see the following from the CDC and WHO: https://www.cdc.gov/coronavirus/2019-ncov/about/prevention-treatment.html; https://www.who.int/emergencies/diseases/novel-coronavirus-2019/advice-for-public.

Conclusion

In sum, COVID-19 has upended the world, its economy and especially its financial markets. But it will eventually pass, owing in no small part to the efforts of thousands of health professionals and others, though perhaps not before infecting many more people. From an investment standpoint, unless we experience an (unlikely) recession, most of the damage to the markets appears to have already occurred. And even a recession isn’t likely to take stock prices down that much more than they’ve already fallen.

Don’t try to be a hero and “play” this decline by radically changing your investments. Keep to your target allocations and let KCS (if you are one of our clients) make any necessary tweaks around the edges.

Yours truly,

The KCS Wealth Investment Management Team

KCS Wealth Advisory is a registered investment adviser. Our services include discretionary management of individual and institutional investment accounts, along with personalized financial, estate and tax planning services.

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