Advisor Talking Points: Oil + Coronavirus, Another Bad Day on Wall Street

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TALKING POINTS

For Financial Advisors

Monday’s overnight stock market futures dropped as much as 5% in reaction to oil prices declining; at one point, 30% as Russia and Saudi Arabia play a dangerous “game of chicken” over the prospect of a global energy glut.  As a result, the yield on the 10-year Treasury tumbled to 0.387%, and 30-year Treasuries were down below 1%.  Yields move inversely to prices.

Here is what this all means.  Oil prices have been dropping for over a year, primarily because of the success of U.S. shale oil producers in increasing global oil production.  Oil prices are down nearly 50% for the year after talks collapsed between Russia and Saudi Arabia.  The Saudi’s slashed oil prices, starting a price war with Russia, to deal with this problem of chronic global oil overproduction.

The now expected flood of oil on world markets, will likely overwhelm inventories and slam oil prices down further — the question only remains as to how much.

Why are the Russians and Saudi’s doing this? The problem with this strategy is that, while these production cuts could help support oil prices in the future, they also keep U.S. shale oil producers in business.  This puts OPEC and its largest producer, the Saudi’s, in the cycle of having to cut production again and again as U.S. shale production keeps climbing and expanding their world market share.  Many OPEC members see this as unfair, but they have already experienced the alternative, and it was worse—falling oil prices for them.

From Russia’s point of view, the Saudi strategy was propping up U.S. oil producers at the expense of everyone else.  They believe the only way this strategy will ultimately work is for OPEC and its partners to keep cutting until U.S. shale oil production began to decline.  The bottom line is, Russia desperately needs the money from its oil exports.  But this strategy is a potentially expensive gamble in refusing to cooperate with OPEC.  They may sell more oil in the short run but at a far lower price.

How Will This Affect the United States?

Effect on Consumers: Most economists believe that cheaper oil translates into lower gasoline prices, which is a de-facto tax cut for U.S. consumers.

Lower oil prices also benefit U.S. manufacturing and other industries that buy or use crude.

Effect on U.S. Oil and Shale Producers:  U.S. shale producers are highly leveraged and, if oil prices remain low for an extended period, it is likely some shale companies could default on their debts.  If Russia doesn’t come back to the negotiation table soon, investors worry many shale companies could default, making banks less willing to lend, and this could ultimately harm the economy.

Capitulation Selling: How Long Will This Stock Market Decline Last?

Between oil and the Coronavirus, the headlines are creating hysteria in the stock market right now!

U.S. stocks have fallen about 12 percent from their closing high on February 19th, which, by historical statistics, is a “modest correction.”  But the stock market hates uncertainty, and with the “unknowns” of the Coronavirus health crisis and the “unknowns” of a significant decline in oil prices on possible future bankruptcies, we may see a new wave of panic selling this week.

At some point in every correction, there is a capitulation point where panic selling dramatically occurs, and then investors realize that all their fears were overblown.  That is always the bottom of the correction, and then the stock market starts a new bull run.

In the fall of 2018, the market started to decline in late September and reached its capitulation point on December 21st over our fears of a trade war with China and the Christmas government shutdown. The stock market declined during that period, 18%.

Over the next two weeks, I believe we could see a total drop from the recent February 19th high to a total decline of 17% to 20% in capitulation selling.

In the fall 2018 correction, the stock market was back to record highs 3 ½ months later.

Coronavirus:  Blip or Black Swan

After watching the network news over the weekend, I can see why people are panicking over the Coronavirus epidemic.  Almost all of the cable and major network news programs were covering extreme scenarios and cases like people trapped on cruise ships or in nursing homes.

Let’s be clear, this is a serious virus, and people need to take sensible precautions to protect themselves.  But as Governor Andrew Cuomo stated on CNN, we all need to step back and take a deep breath, because “the fear and the panic are far worse than the Coronavirus itself.”

Eighty percent of all people infected either have no symptoms or feel like they have a mild case of the flu.  However, it can cause death to older people who have weakened immunity or other health problems.  Dr. Anthony Fauci, director of the National Institute of Allergy and Infectious Disease, said the true fatality rate of COVID-19 “may be considerably less than 1% and may ultimately be more akin to those of severe seasonal influenza, which has a case fatality rate of approximately 0.1%.  Rather than a disease similar to SARS or MERS, which have had case fatality rates 10% and 36%, respectively.”

I strongly suggest that people try to get their information from the Centers for Disease Control (CDC) rather than from social media or the fear-inducing stories on TV news shows.

Unfortunately, this extreme panic is leading people to do some very bizarre things.

  • In Northern California, it was reported that some supermarkets found dwindling supplies of toilet paper and water because of the Coronavirus. I can understand shortages of antibiotics—but toilet paper and water? REALLY!
  • Last week, the shares of Amazon and Alphabet (Google) experienced declines in line with the overall market. That makes no sense!  These companies do not rely on visits from customers.  And one could argue that Amazon’s at-home deliveries should have investors buying the stock during a virus scare.  Both of these companies should be immune to any share price declines.
  • Also, frightened investors are selling stocks and buying 10-year Treasury bonds. How can it be anything other than extreme panic to buy a 10-year Treasury that guarantees a return of less than 1% a year for the next 10-years?  Right now, the S&P 500 has a 2% dividend yield and an earnings yield of almost 6%, based on prior earnings forecasts.
  • According to DALBAR research, the average investor was “blown away by market turmoil in December 2018.” During that month, the stock market dropped almost 17% because of fears of a government shutdown and the U.S.-China trade disputes.  The S&P 500 completely recovered a little over a month later and then went on to record highs.  But the investors who panicked and sold experienced an average loss of 9.4% of their investments.  That was so unnecessary!
  • Less than 50% of U.S. adults get an annual flu shot, so if you are freaking out over the Coronavirus and you didn’t bother to get a flu shot, you’ve got it all backward.

 

The History of Past Virus Panics

Although there are no perfect past market comparisons for the Coronavirus, many Wall Street analysts have shown that the economy and the stock markets have recovered from previous shocks and panics that have temporarily frozen economic activity, such as the 9/11 terror attacks and virus health scares caused by SARS (2003), Swine Flu (2009), Ebola (2014) and the Zika virus (2015-2016).  In all four virus scares, the stock market was higher six and twelve months after the outbreak.

Virus Panics In Historical Perspective:  We’ve Been Here Before!

Oil-Coronovirus-Media-Covers

 

Will This Virus Cause A Recession?

In America, economic contractions are what cause recessions—NOT valuations, political drama, health scares, or even human tragedy.  Today, March 9, 2020, marks the beginning of the eleventh year of this remarkable economic expansion.  Indeed, the absence of a recession over the past decade allowed the S&P 500 Index to rise 2,700 points, a run that defied all others in terms of duration.

S&P Global Research is forecasting the U.S. economy will slow to a 1% annual growth rate in the first quarter 2020 from 2.1% in the last quarter of 2019.  They attribute a 0.5% decline in that number to the Coronavirus.  For the full year 2020 growth rate, the effect of the virus is negligible, shaving one or two-tenths of a percentage point off 2020 growth.  (WSJ, March 2, 2020)

Last week, unemployment dropped to a 50-year low of 3.5%.  Analysts expected job growth for February to be 175,000 new jobs, but the final numbers were a stunning 273,000.  Wages rose year-over-year by 3%.  If one looks at the leading economic indicators, there is no recession in sight, at least not this year.

What About the Chinese Supply Chain Disruption?

Two weeks ago, the Chinese government ordered all manufacturing facilities to reopen in six of the seven largest Chinese manufacturing provinces. Only the epicenter of the Coronavirus in Hubei Province and its largest city, Wuhan, remain closed.

Over 2,500 Starbucks and Nike stores have all reopened in the six provinces.  Volkswagen production facilities have all opened, and Apple CEO, Tim Cook, said last week that Apple suppliers were slowly reopening their plants. Analysts expect most Chinese manufacturing to be in full production within the next two weeks.

This means the Chinese supply chain will have been disrupted for a total of about four-to-six weeks. These supply chain issues should be rectified over the next two quarters. We should see ocean shipping come back over the next six weeks.

Goldman Sachs released a report last week that stated they predict a 0.75% decline in their previously expected 2.4% GDP growth for the first quarter of 2020. They also said that they see continued GDP growth for the rest of the year and no global or U.S. recession, and no long-term economic impact from the virus. We should see the manufacturing and global supply chains return to normal in the second quarter.

I sometimes do not trust Chines government pronouncements or statistics, but Google Maps gave me some confirmation over the weekend in real-time.  Google maps can track pollution in China daily.  You can see by the rise in pollution in the first picture below that China’s factories are now back to work.

 

The first map above shows China’s pollution is almost back to normal, even outside of the epicenter of the epidemic in Wuhan.

The second picture showed the map of the same region during the shutdowns and quarantines several weeks ago.  This map is nearly all in blue, showing lower concentrations of pollution.

From a macro-economic point of view, the real question is, how will this disruption impact the U.S. economy over the coming year.  Once the fear-based panic selling is over, history shows we will most likely see a sharp V-shaped stock market recovery.  Besides having the best health system in the world, the U.S. started the year with robust economic data, and so far, nothing has changed concerning the long-term impact on the economy.

Yes, there will be some earnings declines in the first quarter because of all of the disruptions.  Yes, the travel industry and entertainment and sports companies will feel the brunt of this epidemic’s business impact.  But most factories and stores have reopened in China (except for the city of Wuhan), many of those delayed sales and earnings will be realized later this year.

What Is Causing All The Stock Market Volatility?  Computer Trading!

As I have watched this stock market correction unfold over the past two weeks, I have been struck by the extremely high volume of computerized trading.

The WSJ has reported that typically 52% of all daily trades on the NY Stock Exchange are executed by computers with no human input.  They trade based on proprietary algorithms that follow trends, technical indicators, and other factors.  But no human being is part of the day-to-day trading decisions.  According to the WSJ, they stated that over periods of extreme volatility, as we have seen over the past two weeks, these computer trading models executed over 75% of all daily trades.  This means most human investors are following the trading patterns computers and of only a very small number of humans.

These computer trading platforms are what is driving all the stock market volatility. When the market moves down, these computer trading systems exacerbate the trend and force the market down faster and deeper.  The good news is that when the trend is up, these trading systems also exacerbate the upward trend and force the markets up faster and higher.

Computer algorithmic trading is something relatively new that the industry is going to have to live with, and it has to be explained to average investors who just don’t understand how the Dow can go down one day by 1000 points and then up 1200 points the next trading day.

How Does Computer Trading Affect the Stock Market?

  • During periods of high volatility in the stock market, more than 75% of all trading on the NYSE can be done by (non-human) computer trading program algorithms. And almost all of these programs have a momentum component.
  • Once computer trading programs identify selling, they exacerbate the selling direction faster and deeper.
  • Then, around an hour before the markets close, ETF’s have to sell to stay in sync with their underlying indexes.
  • Once computer trading programs identified that ETF selling, they exacerbated that selling faster and deeper.
  • Then some small investors panic and started selling from their Schwab and Fidelity accounts, and that sets off another round of computer trading programs that exacerbated the selling faster and deeper.
  • And the downward momentum cycle continues until the end of trading that day.

I have been managing money now for over 20-years. I always keep a day-to-day diary of stock market corrections, and I analyze every market correction after-the-fact.  I track going into the correction of how long it lasts, how far it declines, and how long it takes to reach a new high.

In every case—100% of the time—I have found that it does absolutely no good to get out of the stock market during a correction if the underlying economy is expanding and going up, as it is now.

I know that many managers, who usually use 200-day moving averages to get out of the market, temporarily make their clients less anxious.  Still, the overall result is that the client loses money—or doesn’t make what they could have if the investment manager had just stayed in the market.

The problem is that when you sell out of the market as the 200-day moving average declines, the client locks in losses, and those losses are real.  Whereas, if you stay in the market, the losses are simply “paper losses,” and when the market recovers, their gains are real.

I know psychologically the client feels better, and I know that is important. Still, it almost always costs the client a lot of money, because the investment manager has to wait for the 200-day moving average to turn up, and the client has made real losses between when he got out and when he gets back in.  There are also trading costs involved.

Some Good News: The Stock Market Is Now Back To “Fair Market Value!”

On February 21, 2020, FactSet stated that the Forward 12-month Price Earnings Ratio (PE) on that date was 19 times annual earnings for the S&P 500 Index.  That means the S&P 500 was about 13% overvalued compared to its 5-year average of 16.7.

After the last two weeks of market declines, FactSet’s report last Friday, after the close, was the revised Forward 12-month PE is 17.  That is just slightly over the current average of the past 5-years of 16.7.  So, the stock market is almost back to its fair market value as measured by its Forward PE.

Summary:

As I have said before, historically, epidemics have had relatively minimal long-term effects on stocks. It is hard to tell if the Coronavirus will be different.  Right now, it is the time to be thoughtful and not be driven by fear.

Investors should stay put and take no short-term actions in their portfolios, so long as their portfolios are diversified and aligned with their long-term investment plan.  However, whenever there are heightened risks, it is always a good idea to take a look at your long-term strategy to make sure you are on the right track and are adequately diversified.

I expect to see a sharp V-shaped upward correction in the stock market sometime within the next few months.

NOTE: this Report is authorized for distribution to clients

Paul Dietrich is the Chief Investment Strategist for B. Riley Wealth Management.  B. Riley Wealth Management offers comprehensive financial solutions to clients through its network of

over 160 experienced financial advisors across 13 states. The firm manages more than $11 billion in client assets and serves approximately 34,000 client accounts.

IMPORTANT DISCLOSURES:

This analysis and commentary are the opinions of Paul Dietrich, Chief Investment Strategist, B. Riley Wealth Management.

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.

Information and opinions herein are for general use; are not unbiased/impartial; are current at publication date, subject to change; may be from third parties; and may not be accurate or complete. Past performance is not indicative of future results. This is not a research report or solicitation or recommendation to buy/sell any securities. B. Riley Wealth Management is not engaged in rendering legal, accounting or tax-preparation services. Opinions are the Author’s and do not necessarily reflect those of B. Riley Wealth Management or its affiliates. Investment factors are not fully addressed herein. For important disclosure information, please visit www.brileywealth.com/legal-disclosures/

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