The Coronavirus Black Swan
Part 1 — The Current Macroeconomic State
Global markets are dancing a fragile line.
The S&P500 has collapsed -19% in just over two weeks, entering correction territory and possibly the start of a bear market. Based on the Recession Watch indicator, there is approximately a 50% chance of a recession within the next year.
Before the Coronavirus even hit, we were already in the late stages of a Bull market.
So where are we at now?
All the pieces are in place for a potential recession
Global economies today have all the ingredients necessary to spawn a recession, all that is required is the trigger.
The key economic factors present today, which precede recessions, include:
- The yield curve inversion
- Bottoming unemployment rates
- Assets are extremely overvalued
- Flatlined corporate profits
- Breakout in the gold-to-stocks ratio
- The Trigger: The Coronavirus Black Swan
Let’s dive into each of these factors.
Forgot about the Yield Curve inversion?
In the last 50 years, every time the US treasury yield curve inverted a recession followed within 3 years. On average the S&P500 gained 19.1% following the inversion and peaked 13 months later.
The last inversion was 7 months ago and the S&P since rose +16% to all-time highs. While it may seem like this inversion is in the past, the current market behavior following the inversion is the perfect example of historic topping processes which preceded prior recessions.
Unemployment rate at a tipping point
US unemployment is at its lowest level in over 60 years. But isn’t that good?
Not really.
It means the economy is at maximum capacity. Low unemployment rates are typical at the back end of bull markets.
Historically, record low unemployment rates don’t last long, and form sharp V-bottoms. As soon as unemployment ticks up, a recession followed 10 out of 10 times in the last 70 years.
The Coronavirus could be the trigger of that bottoming process.
Assets are extremely overvalued
The Shiller PE ratio, a metric for the relative valuation of the stock market, is also showing signs of topping, similar to previous recessions. A month ago, the Shiller PE was in the top 5% of historic levels for the last 140 years.
This suggests asset prices are at the upper bounds of historic valuations. It may be a good time to consider the phase:
“Buy low, sell high”.
Flatlined corporate profits
US Corporate profits haven’t grown in almost a decade.
Low interest rate environments have created masses of zombie companies, businesses which can only survive due to easy access to credit, but which do not add economic substance to the economy.
In 2018, 16% of US companies were found to be zombies, just able to cover their debt obligations.
In a world of no-fear and inflating asset prices, it is easy for these businesses to be cover their costs and just survive. But as soon as fear kicks in, risk appetites fall, credit tightens and many of these businesses may find they struggle to get financing.
The Gold-to-Stocks red flag
The Gold-to-Stocks ratio just broke above the 200-week moving average. The last time this occurred was in 2001, and for more than a decade investors who ditched stocks and just held gold, achieved a higher rate of return.
The Trigger — The Coronavirus Black Swan
The economic threat of the Coronavirus is not whether or not the virus will have a serious health impacts, but whether or not people think it will.
If people are scared of the coronavirus and take actions to minimize social contact with others for extended periods, then corporations earn less, redundancies follow, unemployment rises and recession results.
Fear driven actions such as cancelling holidays, cancelling concerts, avoiding restaurants and bars, and (at a more extreme level) quarantining entire countries, causes consumers to spend less. Impacts on production and airline demand have already caused flares in the oil market.
The fact that unemployment is a near record lows means such a process can happen quickly. Add to that the fact that many bussinesses are just ticking along (the zombies) and the cascade effect resulting from sustained “social contact fear” could be swift.
It becomes a self-fulfilling prophesy.
It’s not all doom and gloom
While all the ingredients for a potential recession are in place, extremities in markets can exist for long periods of time.
The Coronavirus may be the straw that breaks the camels back, but there is potential that the current market hysteria is short lived.
Infection cases in China have plateaued over the last month at around 80,000.
Assuming the growth rate continues to fall in China and then abroad, global fear and panic may peak (or have already peaked) over the coming weeks and months. Fear levels could subside just in time for markets to recover and not experience significant economic impact.
However, if the Coronavirus fear continues or worsens over the coming 2-3 months, it will likely be too late to control the economic flow on effects that such an environment creates.
A combination of reduced fear plus potentially large rate cuts and other government easing actions might just result in a fast recovery if they happen very soon.
A simple strategy
Given the risk factors today, it may pay to have a reduced exposure to equities (sell the bounces) until markets breakout above current all-time highs.
A strong breakout above current all-time highs would signal a continuing rally. It would also likely mean that Coronavirus fear has subsided, and fresh lows in interest rates and QE may enable the equity bubble to keep growing for a little while longer. Exiting equities now, you would miss a +15% upside if the market rallies from here to the current all-time highs.
However, if you exit equities now and a recession follows through (let’s assume an average -40% drop from in the S&P highs for arguments sake), you will avoid the destruction of approximately 30% of your wealth, and have the opportunity to buy back into cheap stocks.
Consider the following simple equities-or-cash strategy.
Given it is roughly a coin-toss that a recession occurs within the next year, if you exit equities now and re-buy an all-time highs breakout or following a -40% market collapse, you have an expected outcome of increasing your equity holdings by +7.5% (-0.15*0.5 + 0.3*0.5). This assumes that a “no-recession” outcome results in the market rallying to previous all-time highs.
Outlook
We already had all the ingredients for an economic implosion. The overextended economy is the fuel, the Coronavirus is just the match.
If the Coronavirus driven fear subsides soon, we may just avoid a recession.
If it prolongs for the coming months, the likelyhood of recession increases signficantly.
In the near-term, expect a lot of volatility.
Governments and banks will try to support the economy and prevent a potential recession should the virus fear continue. There will be days of positive news and negative news, rate-cuts and stimulus programs. When the recession plays out, there will be “dead-cat bounces” all the way down.
Equity investors would be wise to tread carefully. Dips today may not yet be for buying. The simple strategy outlined above may help you to better manage your equity risk exposure.
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CAPRIOLE INVESTMENTS
Quantitative Asset Management
www.Capriole.com
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