Over the past month, the stock market has dropped by 20%. Largely due to the economic impact of the Coronavirus. As the feeling of panic continues to increase here in the U.S., our clients are asking:
- Should we be buying stocks at these lower levels?
- Is it going to get worse before it gets better?
- How quickly do you think the market will bounce back after the virus is contained?
Having managed money for clients through the Tech Bubble, The Great Recession of 2008/2009, and countless market selloffs, while the circumstances are always different from crisis to crisis, there are patterns that seem to be consistent within each market selloff. Being able to identify those patterns is key in determining what the next move should be within your investment portfolio and I’m going to share those with you today.
DISCLOSURE: Throughout this article I will be using examples of industries and companies. These are not recommendations to buy or sell a particular stock. Please consult your investment professional for advice.
Is The Market Oversold?
When there is a market selloff, one of the key questions we’re trying to answer is: “Has the stock market overreacted to the risks that are being presented?” In answering this question, I think the key thing that investors forget is that a company’s stock price represents more than just one year of its earnings. When investors buy a stock it’s typically because they expect that company to grow over the course of multiple years and yield a generous return. Unexpected events like the Coronavirus without question impact those projections but it’s not uncommon for the market to overreact because it’s focused on what’s going to happen to that company’s revenue in the short term.
A good example of this are the airlines in the United States. Due to the Coronavirus companies have canceled conferences, people have canceled vacations, and sporting events have been postponed or are now being played without spectators. That is a direct hit to the airlines in the U.S. because prior to the Coronavirus they had projected a specific amount of revenue to be generated during 2020 based on all that activity. But here comes the key question. Many of the airline stocks in the U.S. have dropped by more than 50% in the past 60 days. If investors believe that the Coronavirus will eventually be contained in the coming months, are those airlines really only worth half of what they were 60 days ago?
Buffett’s Words of Wisdom
I hesitate to use Warren Buffett’s famous quote because it’s used with such frequency but it’s proven to be a valuable investment practice during times of uncertainty: “Be fearful when others are greedy and greedy when others are fearful.” While it’s easy to say, it’s very difficult to execute effectively. Buying low and selling high goes against every human emotion. It often means stepping into the most unloved names, at what would seem to be the worst time, and owning that decision. Right now those investments seem to be the airlines, hotels, cruiselines, oil companies, and other industries directly tied to travel and tourism.
This same concept also applies to the decision to “hold” or not sell your equity holdings when the market is in a panic. Even though no one likes to see their investment accounts lose value, if you were positioned appropriately prior to the start the Coronavirus pandemic, in my professional opinion, you should not be making any adjustments to your portfolio given the recent market events. If however, you were allocated too aggressively based on your own personal risk tolerance or time horizon, you have a much more difficult decision to make.
Short Term vs Long Term Risks
Market selloffs are typically triggered by two types of risks: short term risks and long term risks. Being able to identify which risk the market is facing should greatly influence the decisions that you are making within your investment portfolio.
I’m going to use the airlines again as an example. In my personal option, the Coronavirus represents a short-term risk to the airline industry. In an effort to contain the virus, conferences have been cancelled, companies have told their employees not to travel, people have canceled vacations, etc. But you have to ask yourself this question: “what’s likely to happen once the virus is contained?” Conferences may be rescheduled, business travel resumes, and people map out a new plan for their vacation. There is arguably pent up demand being created right now that the airlines will benefit from once the virus is contained.
Back when 9/11 happened, I viewed that risk as a longer term risk for the airlines because people could choose to permanently change their behavior and choose not to fly for a very long time based on that event. In the 2008 financial crisis, the banks had a long road ahead of them as they executed plans to dig out of their leveraged positions. Problems of this nature usually require more time to fix which is why these longer term risks can justify a move from stocks into bonds.
Winners and Losers
Even with short term risk diversification is key. Just because a risk is a short term risk does not necessarily mean all companies are going to survive it. There is a risk to all companies that are impacted by market events that they run out of cash before the tide turns back to the upside. If you are an investor looking to buy into airlines at these lower levels, it’s typically prudent to buy multiple companies in smaller increments, as opposed to establishing a large position in a single airline. Again, just an example, if you decide to buy stock in American Airlines, Delta, Southwest, and United Airlines, the risk of buying low is one of the four may run out of money before the virus is contained and they are forced with filing bankruptcy without a bailout from the government. If you put all of your money into one airline, you are taking on a lot more risk.
One of the lessons I’ve learned from buying during a market selloff is you need to keep your long-term perspective. Meaning when you purchase a stock that has dropped significantly, there are forces acting on that company that could cause it to drop by more. You have to be comfortable with that reality and you have to possess the time horizon to weather the storm in the likely case that it could get worse before it gets better.
It’s all too common that investors purchase a stock thinking that since it’s already dropped 30%+ that it can’t possibly go any lower, only to watch it drop by another 30% and then feel pressured to sell it thinking they made a mistake. I call this “buyer’s remorse”. When you play the role of an opportunistic investor, it may take months or years for the benefit to be realized. Investing for a “quick pop” is a fool’s game, especially with the Coronavirus situation. No one knows how long it’s going to take to contain the virus, how badly Q1 and Q2 revenue will be hurt for companies, or will it end up causing a recession. Making the decision to buy stock at lower levels is usually based on the investment thesis that the stock market is overreacting to a relatively short term event and those companies getting hit the hardest will recover over time.
How Much Time Will It Take For the Market To Recover?
No one knows the answer to this question because we have never really been in this situation before. We have been through other epidemics in the past such as SARS, MERS, Swine Flu, and Ebola, but nothing that spread as quickly or as broadly around the globe as the Coronavirus. Since China was ground zero for the virus, the good news is we are already seeing significant progress being made at containing the virus.
As you can see via the blue line in the chart, at the beginning of February China was reporting thousands of new cases every day, but since the beginning of March the line flattens out, meaning the number new people getting infected is tapering off. If the United States follows a similar trajectory, we may see the rate of infection rise significantly in the upcoming days only to see the numbers taper off a month or two from now.
I would argue that we have an added advantage over China and Europe in that we had more time to prepare, we know more about the spread of the virus, and how to contain it. I think the lesson that we learned from Europe was you have to be aggressive in your containment efforts which is why you are seeing the extreme measures that the U.S. is taking to contain the spread of the virus. Those extreme containment efforts hurt the market more in the short term but will hopefully result in less damage to the economy over the longer term.
It’s really a race against time. The longer it takes to contain the virus, the longer it takes for people to get back to work, the longer it takes for people to feel safe traveling again, which results in more companies being put at risk of running out of capital waiting for the recovery to arrive. This is the reason why the Fed is aggressively dropping interest rates right now. Dropping interest rates does absolutely nothing to contain the virus or make people feel safe about traveling but it provides companies that are struggling due to the loss of revenue with access to low interest rate debt to bridge the gap.
A Recession Is Very Possible
A recession is defined as two consecutive quarters of negative GDP growth. With the global slowdown that has taken place in 2020, the U.S. economy may post a negative GDP number for the first quarter. Since it takes a while to bring global supply chains back online and for consumers to return to their normal spending behaviors, it’s possible that the U.S. economy could also post a negative GDP number for the second quarter as well. By definition, that puts the U.S. economy in a recession. But it may end up being a very brief recession as the Coronavirus reaches containment, global supply chains come back online, pent up demand for goods and services is fulfilled, and U.S. households and businesses have the dual benefit of having access to lower oil prices and lower interest rates.
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.