This post will look at the recent slide in the global equity markets, largely attributable at the moment to the unknown effects of the Coronavirus. I will make the case that the market was ready for a correction because global economic growth (and growth in the U.S.) has been slowing and valuations have edged towards the expensive side. If you can’t sleep at night, perhaps you’re too long equities. Otherwise, keep in mind that the CAGR of the S&P 500 since 1959 (60 years) has been 10.15%/annum on a nominal basis and 6.3%/annum on an inflation-adjusted basis, in both cases assuming dividends had been reinvested (source: moneychimp.com).
The global equity markets started to slide on Friday but really tanked the last two days. How badly you might ask? The gory detail is in the table below.
The damage has been most acute in the US equity markets, which have more or less experienced a steady trend upwards for several years now, enduring several setbacks here and there along the way. Even after two days of severe losses, investors are still no worse off that they were in early December. Here is how the S&P 500 has performed over the last five years:
It is perhaps a bit too convenient to say that the cause of this correction is only Coronavirus, even though as I write this, the footprint of the virus is spreading quickly outside of Asia with Italy particularly badly affected now (and economically vulnerable). It is impossible to say if this sudden downward spiral in global equity markets has been caused solely by the economic effects of Coronavirus, or if the virus was the simply the catalyst that tipped us off the point of the iceberg, where arguably the market has been teetering now for several weeks. Recall that Coronavirus was first mentioned publicly by the Chinese government on January 12th (see announcement from the World Health Organization (“WHO”) here). Even though the cases of and deaths caused by Coronavirus were spreading fairly quickly throughout China and there was clearly risk that it could spread abroad, this potential “black swan” event seemed to remain largely irrelevant to equity investors, that is until late last week. The reality is that the spread of Coronavirus was well documented, with more and more cases, deaths and locations being reported each day. There was a high risk from the onset that the virus could spread beyond China because it had clearly not been contained and has an incubation period of around 7 days.
Why did investors remain complacent during the first several weeks of the Coronavirus? Probably because they have become conditioned to behave this way. Time and time again over the last several years, investors have had to navigate speed bumps. Yet on each occasion, they have eventually buried any concerns as the market righted itself and returned to growth, often with even greater vigour and conviction. Perhaps the most memorable time recently was 4Q2018, when it felt we were headed down without a floor in sight, but then suddenly, the new year brought renewed investor enthusiasm and the market restarted its march upwards towards realising the best annual return in many years (31.3% in 2019, including dividends). The fact is that this one-way trajectory up probably needed another rest, because investors - certainly retail investors – had become too complacent, forgetting that high returns are not possible without higher risk. How easy it is to forget this is not a one-directional market – only 12 years ago during the depths of the Great Recession, the S&P 500 lost over 30% in one year!
I am not doubting for a minute that Coronavirus is indeed a great unknown. Anywhere the virus has appeared, it has brought economic activity to an abrupt halt because it is so contagious and can cause death. However, I also believe that the virus is not the only thing contributing to this severe market sell-off, as economic growth has been slowing and valuations have been becoming more expensive. Let’s look at these two things. 1. Global economic growth is slowing nearly everywhere, but most importantly in two of the world’s largest economies – the U.S. and China - which collectively account for almost 40% of world GDP. Aside from moderating growth in these two economic growth engines, the European Union (as a bloc 22% of global GDP) is barely achieving 1%/annum growth, and Japan (5.7% of global GDP) is growing at only 0.7%/annum and is on the brink of recession. Look at the trends in the table below over the last nine quarters – there is not an economy that matters in the world that has not been slowing.
Slowing global growth was happening well before the Coronavirus appeared. Many countries around the world face economic headwinds, including the US, although the breadth, strength and resiliency of the US economy remains better than most countries. Even so, slowing economic growth will eventually translate into slower earnings growth for many economy-dependent companies. This fundamental reality, in turn, would cause stock price growth to moderate anyhow (multiples aside). Before I leave this point, remember that many central banks are out of ammunition as far as potential monetary stimulus, and the governments of other countries - such as in the Eurozone - seem incapable of developing and implementing any fiscal stimulus to coax their economies into the next gear of growth. In summary, the global economy seems to be in for choppy waters. 2. Global equity markets are getting more expensive. The U.S. equity markets look increasingly expensive compared to historical levels and to other countries’ equity markets. The P/E of the S&P 500 is around 23.55, which as the chart below indicates, is not entirely unreasonable but is certainly pointing towards stocks being fully valued.
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For relative comparison, the P/E ratios of other markets are: FTSE 100, 16.95 (end of January); the STOXX 600, 15.3 (end of December); and the Nikkei 225, 21.44 (end of December). All of these make the S&P 500 look even more expensive on a relative basis, but one must keep in mind that both economic growth and earnings growth have been much better for US companies, so perhaps their higher multiples have been earned. So where does this leave you if you are an investor in the stock market? If you are having trouble sleeping at night through the severe volatility of the last few days, then you might be too long equities in your portfolio. Staying fully invested in stocks, fully out of the equity market, or just halfway in stocks (i.e. diversified across asset classes) has to be put in the context of i) your time frame for investing, ii) your need to liquidity (meaning cash), and iii) your own risk tolerance. Of course, this does raise the question of where to put a portion, or perhaps al,l of your hard-earned money if you are losing your taste for equities. US, European or Japanese bonds? I’m not so sure. You will earn negative yields in both Europe and Japan. I believe that generally the risk is now as high investing in government bonds as in equities, at least in terms of future price action. Cash? Enjoy earning nothing on your money, or - in some countries - paying a bank to keep your money on deposit. Safe haven assets like gold? Other asset classes like real estate, private debt or crypto currencies, to name a few? This is personal taste and tolerance, but always keep in mind both the potential volatility of an asset class and its liquidity (or lack thereof). Remember - if you do not need the money for some period of time, the equity market has offered the best risk-reward return of almost any asset class over a long period of time.
If you want to know what I am doing having said all this, I am a long-term equity investor. I generally conform to a “buy and hold” approach with a diversified portfolio of individual equities being a very significant part of my portfolio. Although the past few days have been undeniably painful, I can sleep at night for this reason - I am in this game for the long haul.