Where is the bottom?

Is the Sharp Pullback Justified?

The stock market drop of the last two days has brought us back to its value on December 6th.  You can see from the chart above that the fourth quarter of 2019 delivered a steady market rise that was interrupted in late January, then again, forcefully, this month.

When the coronavirus outbreak was reported to be growing rapidly in China during the start of Lunar New Year celebrations last month, the stock market had a quick pullback and then recovered. 

Now we are starting to see the economic effect of quarantines, with factory shutdowns and supply chain disruptions in China, travel cancellations, and lower oil prices.  Investors are taking the threat more seriously.

Because the stock market price and corporate earnings are highly correlated, we wanted to calculate the potential downside based on the likely decline in earnings due to the virus. Some of the possible demand decline will be just delayed purchases (waiting to buy a car or house until the outbreak is contained) and some of the decline will be a real loss (for example, cancelled travel plans and fewer restaurant visits can’t be recovered).

How bad will the market react?

Estimating Coronavirus's Impact on the Economy

February is the height of corporate earnings reports for the previous year’s results.  Growth was below average for 2019, but it was better than analysts feared so the stock market had been reacting positively.

Earnings growth for 2020 is expected to be much better than 2019.  Wall Street analysts are forecasting earnings growth overall of about 7.7% in 2020.  The big unknown is how much they will be impacted by the virus.  How much will people stop shopping?  Will companies have to shut down production to protect workers, as is happening in parts of China?  Can authorities keep the virus contained so that it only affects some regions, or will there be wide-spread quarantines?

Obviously it is too soon to know.  But if we estimate that earnings growth for the full year is cut in half by virus, then the stock market pullback could continue to decline by another 2-5%.

If we lose all of the earnings growth expected for 2020, which would be significant, then the decline could be another -6 and -11%.

If the economy gets thrown into a recession, then it could be another -15%.

And what happens after a decline?  A recovery.

Potential Downside…But Impossible to Time It

The biggest threat to the stock market is always the unknown.  Wall Street ignores the real human impact of the virus and only cares about how it will ultimately impact companies.

In the past, when companies experience high uncertainty, stock declines are usually sharp.  And when investors have a better understanding of the threat, even when it hasn’t gone away, the recovery is often quick too.

This is the reason why no one has consistently been able to time the market.

At this point we are staying the course, even as we are cautious and tracking the disease progression.  We aren’t expecting this to cause a recession, and if we are wrong and the market declines more than expected, we anticipate that we would shift the portfolio to a slightly more aggressive stance.

At Archer Bay Capital, we help clients better understand the market volatility so we can make better financial decisions together.  Contact us to discuss stocks, earnings and our forecast in greater detail, or to schedule a consultation today.