Down with the Corona Virus Mr. Market is shivering — Scientific Investors should be loving it
With the Corona Virus panic infecting Mr. Market, the global markets have fallen 7% to 10%+ in the last one month. Individual stocks might have fallen even more. The panic is increasing with the number of countries reporting infected residents and deaths. Further, the number of infected persons and deaths are increasing. Reports and estimates of actual numbers being higher than reported are making the rounds. Further, there are reports claiming that this is one of the greatest risks to the World and comparing it to large-scale real-word infections, such as, the plague or to virtual-world infections, such as, Zombie Apocalypse and Resident Evil.
Trade and travel with China is heavily restricted and is being extended to other countries which are reporting large-scale infections. China has the largest share of global exports at 12%. Further, many companies across the world source goods or raw materials from China and many others sell finished products to China. It seems that Q1 (Jan-March) 2020 GDP of China is severely impacted due to the trade and travel restrictions and this is likely to continue in Q2. Naturally, the companies dependent on it for sourcing or end-markets are also likely to be impacted. The end-result of all this is that Mr. Market is down 12%+ from February peak. Since the last week of February the market has been going down nearly every day, and there is general panic in Mr. Market’s mind.
The question on most investors’ mind is: What is the course of action going forward?
Mr. Market thinks that it is natural that when the whole world is at health and economic risk then how can the companies do well, and the companies of the world should be valued lower. Directionally, this makes sense since we are losing some global trade with China and possibly the other already infected or to-be-infected countries. The drop in global trade would impact global GDP, i.e. revenues of companies and consequently their earnings and cash flows. The loss of cash flows should translate to a loss of value in the company valuations to the extent of the drop in the magnitude of cash flows. So far so good.
While all this is logically consistent so far and hence Mr. Market’s drop as a consequence of the Corona Virus too seems logical.
The OmniScientist knows that the best opportunities lurk when Mr. Market’s reactions are logically inconsistent. The next-best opportunities lurk, and this is relatively subtle, when Mr. Market’s reactions might be logically consistent but quantitatively inconsistent. So let’s start assembling some data and quantifying the estimates.
World GDP is around $90 trillion and global merchandise exports is around $20 trillion, i.e. 22%. China has a share of around 12% in global exports, i.e. $2.5 trillion. China’s imports is around $2 trillion. China’s annual global trade is around $4.5 trillion. This will be impacted for around 2 quarters, i.e. half the year. Let’s say it drops by 50%, meaning impact is 25% of the annual global trade of China, i.e. around $1.125 trillion. The global GDP will drop to that extent. On a $90 trillion economy, the direct impact could be up to 1.25%. There could be a multiplier effect and let us assume that it is 2. In this case, the total impact, direct and indirect (due to the multiplier effect) would be about 2.5% drop in GDP for 2020. The global nominal GDP growth rate was expected to be around 6% for the year prior to the Corona Virus event. With this scenario, it looks like it would be around 3.5% if the impact is as calculated above.
Let us assume that because of this slower global GDP growth of 3.5%, all the earnings growth of the listed companies in developed markets for the year are wiped out, although that is unlikely. The expected growth for the developed markets companies was 4% and now it is zero. That means the total intrinsic value of the companies that has been destroyed by Mr. Market is 4%. How much have the markets dropped by?
Exactly. Around 8 to 10%. So if they were buy-worthy before, now they even more so.
Now let us do some second order analysis. It is likely that the governments of the world, especially the ones seeing high impact on their global trade and domestic consumption are likely to compensate that with fiscal stimulus, monetary stimulus and trade stimulus. Which means the economies are likely going to be less impacted than assumed above. Further, monetary stimulus is likely to be a rate cut by central banks, or at least more accommodating policies.
Third-order analysis is that a loss for China in trade is going to be a gain for domestic companies which could step in with supply replacements and also for other countries which could provide substitutes or replacements. This could again reduce the impact on the revenues and earnings of the listed companies.
All in all, at current levels the market provides a higher expected return and Mr. Market is over panicking. The Scientific Investor would ideally allocate more over the next few months while the uncertainty and panic remains and Mr. Market remains undecided between flight and freeze.
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