COVID Shocks. We’re Bullish.
The spread of the novel COVID-19 virus has sparked not only suffering among afflicted people in over 100 countries around the globe but also unprecedented upheaval in public health policy. Financial markets have been severely impacted as well. From an all-time high of 3386 reached on February 19th, the S&P 500 Index recently traded at 2569, a decline of 24%, signaling the beginning of a new bear market. For perspective, over the past 60 years, the S&P 500 Index has sustained a decline of 20% in only three years - 2008, the onset of the financial crisis, 2002, the hangover from the dot-com bust and 1974, the worst recession since the Great Depression. Historically, earnings declined by more than 20% only in 2008 and 2002. The global pandemic appears to have the potential to match or exceed prior periods of market disruption and economic dislocation. Global supply chains have seized up, travel - both tourism and business - has ground to a halt, many leisure activities have virtually ceased. As the following table illustrates, every S&P sector has been impacted and all are in or close to bear market territory.
As shown above, energy and financials have been the weakest performers of the 11 sectors defined by Standard and Poors. The energy sector was buffeted by an unexpected move by Saudi Arabia to break with OPEC and boost production. This supply increase, combined with the likely decline in oil demand in the context of subdued economic growth, drove benchmark crude prices down 52% from their January highs. Price performance in the financials has been driven by bellwethers such as Mastercard, impacted by travel woes as well as money center bank exposure to weaker economic activity.
We are actively managing positions to control risk, identify holdings more likely to be slower to recover and build exposure to those quality companies likely to emerge stronger from this downturn. Our expectation is that conditions of uncertainty and fear will persist for at least the next quarter, with negative implications for earnings growth, greater volatility in market pricing and continued aversion to risk assets. Using history as a guide, we believe that the combined resources of the global community will successfully control this outbreak and limit its impact on the global economy by the Q3. Between now and then, we expect most of the companies we hold to reduce earnings expectations for at least 2020 with some predicting a negative impact extending to 2021. Assuming a 30% drop in earnings, which would mirror the declines observed during the Great Recessions of 1974 and 2008, the S&P would earn approximately $120 in 2020. Applying a 18 multiple to this figure yields a downside price target of 2142, down approximately 16% from current levels. We’d expect earnings to recover in 2021, suggesting EPS potential of nearly $180, which would support price recovery to nearly 3600 or 40% above current levels. As such, we view the risk/reward as favorably balanced towards increased commitments to the market, notwithstanding how unsettling this volatility can be.
As always, we are deeply grateful for your trust and confidence as stewards of financial well-being. If we can assist in any or elaborate upon our views on the economy, market direction and/or financial planning, please be in touch.