U.S. Equities COVID-19 Bear Market
The U.S. equity market has entered bear territory with a quick 20% drop since February 19. Speculative players are now in full bearish mood, while institutional players have shifted to offloading some vulnerable holdings. Where will the S&P500’s bottom be?
Valuations in equity terms are not yet cheap for the U.S., which has normally been one trigger at the end of a bear market. However, this was not the case in 2009 when much lower government bond yields and huge fiscal policy stimulus put a bottom in place. The key this time is the peak of COVID-19, and the answer does not look pretty.
A number of points are worth making re COVID-19:
- Vaccine. The long-term silver bullet is a vaccine for COVID-19 that is effective in protecting the vast majority of the population. This avoids social distancing with supply and labor disruption and significantly reduces consumer anxiety. Estimates from the medical community remain in the 12-18 month timeframe for DM economies, due to testing requirements. China progress could be quicker and needs to be monitored for a potential solution.
- Peak COVID-19. Figure 1 shows healthcare strategies of social distancing can reduce the overall number of cases and also the peak number of cases that a healthcare system faces. However, this comes with economic costs as it requires event postponement; school closures; work from home or curtailing production. Chinese data so far show that the temporary economic impact can be huge and the risk is that Germany, Spain and France will likely introduce selective quarantines and other measures in the coming week, given their case trajectory is around 10 days behind Italy. Even so, hot weather has in the past tempered colds and flus, while the containment in SE Asia has already had some arguing the same point about COVID-19. Part of the delay and migration strategy of social distancing is that the rest of the Northern Hemisphere can allow the peak to be smaller and pushed toward hot weather.
Figure 2: Three Waves of the 1918-19 Flu Pandemic
Source: UK government
- COVID-19 spread. The WHO and EU have emphasized that COVID-19 does not spread as quickly as flu and is more due to droplets. This creates uncertainty within governments, as most pandemic plans were based on a new flu pandemic that spreads more widely and quickly than COVID-19. It may mean that estimates of 60-70% of the population being infected are too high and we have previously used 8% in our major and severe pandemic scenarios. From Figure 1, we would say an additional 2-4 months in Europe and the U.S. before the peak has clearly past.
- Second or third waves. The 2009 swine flu virus saw two waves, while the 1957-59 flu pandemic stretched over two years. The 1918 Spanish flu pandemic came in three waves (Figure 2), though the WHO notes that COVID-19 has not seen a major adverse mutation, which did happen with the second wave of the 1918 pandemic. China and South Korea appear to have contained COVID-19 for now, but the crucial test will be whether a full return to work produces a new outbreak or whether autumn 2020 in the Northern Hemisphere produces another one. From previous pandemic experience, further waves are probable in the autumn rather than possible, with the caveat that previous deadly coronavirus events have died out quicker (e.g. SARS).
What does mean for the S&P500 bear market? We feel that using the Chinese experience of the daily number of new cases peaking over a one-two month period (Figure 3), will likely be an underestimate as other countries are reluctant to undertake the full-scale shutdown seen in China. We thus pencil in a further two-four months before a clear peak in Europe and the U.S. Equity market sentiment will likely be temporarily supported by stimulative measures as has already been seen from the Fed, the UK and a number of Asian economies. However, this stimulative narrative is not yet on the scale of 2009, due to policy constraints on monetary and fiscal policy. Additionally, the cooperative spirit of the G20 in 2009 is missing. Trump’s labeling of a foreign virus plays a domestic political blame game rather than global leadership. This narrative may not change much in the near-term until the U.S. cases of COVID-19 climb to Italian or Chinese levels. Trump knows that it will take time to agree a fiscal stimulus package with the House Democrats and the odds remain that the first package will not be on the scale of Barack Obama’s action in 2009.
Figure 3: Daily Number of New Cases
Earnings downgrades will also likely feed the bear market. S&P500 2020 earnings have not been adjusted sufficiently to a pandemic that avoids a full-scale U.S. recession. We feel that 2020 S&P500 earnings could eventually be cut to 150 per share (-8% versus 2019). Bear markets normally end with cheap valuations and an exhaustion of the negative news flow. One argument is that the 2009 bottom has shown that the market does not need to be cheap on long-term valuations provided that the Fed aggressively cuts rates and government bond yields fall. Using the March 2009 12mth forward P/E ratio of 12.6 would translate into 1920 on the S&P500 using 2020 S&P500 earnings at 150. Being generous and assuming a COVID-19 vaccine, containment and economic recovery could produce a ballpark of 2021 S&P500 earnings of say 165-170. If the equity market were forward-looking then this would mean value at 2100-2200. Note these are not the worst case, where a deep U.S. recession would be triggered by a major or severe pandemic.
Bear markets also have sharp multi-week squeezes as well as the one-two day technical rallies that we have seen since February 19. Candidates for causing squeeze will likely include aggressive Fed action on March 18, where 50bps is now expected—but it is possible that the Fed could cut 75-100bps and promise the start of QE4. Second, the G20 will likely hold a conference call soon and promise action, though markets will also want to see detail. Third, the pandemic could become regional rather than global, centered on Europe and not Asia/EM, which would allow the market to think about recovery in Asia. Fourth, the Saudi-Russia oil price war will come to an end in the next few months, given that Vladimir Putin needs to boost popularity before the September 2021 Duma elections (though this is double-edged, as many economies will eventually benefitting from lower oil prices).
All of these catalysts can produce sharp rallies, but without COVID-19 cases peaking, we would remain bearish. Our initial target of 2700 from March 4 has now been met and our multi-month target is 2350.