What COVID-19 Means for the Market Now and What to Expect Next
By James Cakmak and Ryan Guttridge
Let’s start with the facts. Despite a disastrous initial response to the outbreak of COVID-19 from Chinese officials, it appears that things are starting to get under control within China’s borders. Our sources on the ground attest to this. Elsewhere, however, the plans and procedures in dealing with the virus are less assuring.
Bottom line, nobody knows how bad the pandemic can get. And anyone saying otherwise is insincere. But if history is any guide, we’ll get past this.
Given the increased uncertainty and high expectations, the markets sell-off last week seems justified.
So what are investors supposed to do? There are 3 key questions to consider:
- How low can the market go?
- What does this mean for the Market’s earnings for the rest of the year?
- What are the business and technology implications going forward?
Let’s tackle each.
How low can the market go?
It’s helpful to analyze the market in terms of the frequency of valuations versus averages. 75% of the time the market trades between 9x to 19x earnings. Dating back to 1871, the market has traded north of 20x earnings during just 15% of the time. We were essentially pushing against one of those times prior to the correction.
In addition, 70% of all S&P components were trading above 20x, with 60% actually over the 25x threshold.
Now, a lot of air has been taken out. Those figures are down to 60% of components above 20x and 43% over 25x. In aggregate, the S&P is now sub-18x earnings, within the area it spends most of its time.
Provided that the market’s aggregate earnings don’t fall off a cliff or are basically flat with last year…we’re getting close. What we need to see for a bottom is for the majority of stocks to fall below the 20x mark.
What does this mean for the Market’s earnings for the rest of the year?
If we were business managers, this is the time to kitchen sink guidance for 2020. We suspect that should be the case for most companies.
There is so much uncertainty as it relates to overseas supply chain relationships and demand that they will not know the extent of pressure to earnings.
What we do know, however, is that the days of China making all of our stuff is effectively over.
Taking the supply pipeline out of China will be long and painful. Most of big tech is also operating at peak margins, mind you. We wouldn’t be surprised to see flat earnings for the S&P in 2020 and conceivably even down.
On the flip side, as long as these transitions are gradual, valuations can stay at the high end of the range.
What are the business and technology implications going forward?
As the Cloud began to emerge, venture capitalist Bill Gurley said: “We’ve spent the past 40 years putting technology inside the enterprise and we’re going to spend the next 20 years ripping it out”. That same logic is apropos as it relates to the supply chain in China.
Technology has dramatically increased cooperation across the world and businesses spent decades building out supply chain relationships. On balance, these decisions were cost driven. That calculus has now shifted.
There are two key takeaways.
The first point is that this solidifies our upperhand in China trade talks. China knows that any supply chain losses will be permanent. Why would a company want to deal with diminishing cost savings and risks of intellectual property theft? Second, business managers are finally in a position to re-prioritize productivity gains over relative cost advantages.
Think about where we are. The move to the cloud has set up an enormous opportunity. Henry Ford increased productivity six-fold with the assembly line. With the Cloud, 5G, AI, and 3D printing, multiples of improvement beyond that are possible. Think about the gains made by the Gutenberg Press, transatlantic cable, and assembly line, all at once.
All of this is good for the US economy over the long run. They just needed a catalyst to get there, as unfortunate as this one is.
Clockwise Capital is an asset management firm with a private equity approach to the public markets. We focus on the meaning of time and the role it plays in people’s lives. We believe the essence of a great investment resides in the ability of a company to either save their customers time, or improve its quality. We understand how technology evolves to drive these two factors, which we believe define human progress. As a result, we search for securities with cyclically depressed valuations whose companies save time, thus using secularly advantaged industries to build a concentrated portfolio. With each series of investments our goal is to optimize edge, maximize return, while also minimizing correlation. This allows our portfolio to maintain a liquid, low duration fixed income balance, ready to capitalize on market volatility, while still generating market beating performance.
