Coronavirus Hit Not As Bad As Feared; Closing Correction Call
The outbreak of the awful coronavirus in China over the past weeks has had everyone running scared, including me. I “freaked out” in terms of what I feared it might mean for the stock market, among other things. Initially, I suggested (on January 27) the Standard & Poor’s 500 index could correct toward 3150 as a consequence of the effect on the China and global economy, through reduced travel and production, etc.
I happily admit, however, that perhaps that was somewhat too cautious. Specifically, the combination of the coronavirus risk, plus the potential MAX 737 hit to Boeing (BA) production and results, and the risk-off indications in the credit and VIX markets had pointed early on to an expected rise in “equity risk premium.” That would mean a falling price/earnings ratio.
Yet after a few sloppy days of trading, the 11-year old bull market just picked up where it left off in mid-January and began recording new highs again. Remember, price is signal and investors should always pay attention to it. Hindsight is 20/20, of course, but I believe that the solid stock market recovery negates my previous near-term correction view. In the event, the SPX “correction” in late January-early February was about 3.7%, high to low.
More importantly, perhaps, is that in the past week, incoming data has on balance strengthened our bullish 2020 thesis and outlook.
There are five reasons I see for why the “correction” hasn’t worsened or endured.
- INCOMING DATA STRENGTHENS OUR 2020 THESIS → US OUTPERFORMS. Among my non-consensus views in 2020, I argued investors should overweight U.S. equities, given favorable demographic trends and sector composition. The seismic epicenter of the coronavirus hit is amplifying this argument.
2. Overweight U.S. vs CHINA → U.S. ISM VS CORONA HIT TO ASIA GROWTH. Incoming data this past week showed U.S. growth resilience (textbook recovery) in the Institute for Supply Management (ISM) Purchasing Managers Index (PMI). The recovery is tracking the U.S. Treasury 30-year-10-year yield spread advanced by 16 months, a model presented in these pages previously. As clients know, we view the 30Y-10Y yield curve as the ‘Jedi’ of curves. It has an unblemished track record long term, having lead the ISM Manufacturing survey by 16 months consistently in the last three business cycles (see our 2017 report on this, upon request). Last year, using the 30Y-10Y curve, I noted the ISM manufacturing should recover to >50 by fall or early 2020. This turn was indeed “textbook,” per the 30Y-10Y curve and pointing to a sharp recovery in ISM in 2020. See chart.
The PMI improvements are strongest in seven years with ISM one month change the best since July 2013 and the four months delta in exports the best since April 2011. This supports my view that SPX EPS growth likely is closer to 15% in 2020 vs the consensus of ~9%.
The October ISM Exports posted a 50.4, a sharp rebound from September’s 41.0, lowest since the Great Recession. As shown on table nearby, each 1-point increase in ISM Exports adds 0.6% to S&P 500 EPS growth. The recent ISM reading of 50.4 is 9.4 points higher than September. History suggests S&P 500 EPS growth should rise by 545 bps. I believe this recovery reflects an abating of oil shock, weakening U.S. dollar, and generally improving conditions.
3. EQUITY RISK PREMIUM COLLAPSING → TSLA POSTER CHILD. Thestupendous surge in Tesla (TSLA) shares this week is evidence thatthe equity risk premium could be falling sharply in 2020. This hasbeen central to my view that the U.S. market P/E could rise in 2020 (see notes from January). If correct, TSLA’s strong move shows the dramatic impact this has on price.
4. Overweight US DEFENSIVE TRADE → S&P 500 GROWTH INDEX VS RoW (rest ofworld). If gross domestic product (GDP) growth visibility weakens, then I expectinvestors will gravitate to growth stocks. Indeed, since start of year, MSCI Growth hastopped Value by 520 basis points (vs flat for much of 2019). And in fact, the S&P 500 is essentially a large-cap growth index with the latter representing 57% of index(adjusting for Apple (AAPL 4.5%), which was oddly in the Value bucket in 2019).
5. Overweight US LARGE-CAP STYLE → S&P 500 LIQUID, LARGE-CAP VS ROW MID-CAP. U.S. trading volume is about $2 trillion per day, or about ten to 20 times thevolume of other country exchanges. Hence, if investors are gravitating to liquidity inthe risk-off world, U.S. stocks benefit.
What could go wrong? I am closing our tactical “short-term correction” view given the resilience in markets and the five factors cited above. But the coronavirus risk remains on the horizon and I don’t believe equity markets have priced in the potential of a pandemic spread to developed nations (still largely in China).
Bottom line: We see >10% upside in S&P 500 in 2020, with gains likely towards 15% and maybe 20%. Those gains are driven by >10% EPS growth (upside to that) and falling equity risk premium (100 bps = 2 turns = 10% rise in stocks).
Figure: Comparative matrix of risk/reward drivers in 2020
Per FS Insight
Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/10/2019
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