Stocks, so the argument goes, are being driven by low interest rates, buybacks, cuts in corporate tax rates and a scarcity of investment alternatives—everything but solid fundamentals and organic growth. Wharton University’s Jeremy Siegel, among other experts, has completely altered his forecast of a 5% increase in S&P 500 profits in 2020.
Recession Highly Anticipated
Now he believes the collateral damage from the coronavirus could send earnings on down by as much as 20%. That would be “dramatic, and of a recession magnitude,” Siegel said on a March 10 podcast.
But Siegel also observed that if the U.S. was going to suffer a recession, the timing, with 3.5% unemployment in a strong February jobs report, was propitious. “If a patient is going to get sick, what the doctors say is the most important thing is he goes into that sickness being healthy. That will mean he or she will recover the fastest,” Siegel explained.
Investors’ expectations also are returning to reality, albeit in an abrupt, painful fashion. In the final months before mid-February, Siegel observed markets “were riding too high” in a momentum-driven environment.
With the S&P 500 down 27% as of March 12, markets are no longer living on what skeptics might call their own Fantasy Island. In a matter of weeks, the Shiller CAPE ratio fell from a lofty 32 to a more reasonable 23. But trying to estimate the value of financial assets in the face of an unknown like a pandemic is a daunting task.
Economists at Vanguard estimate the fair value of the S&P 500 to be somewhere between 2,600 and 3,300. That would mean it overshot the low end of the range in March when it fell below 2,500. That estimate, of course, changes with interest rates, inflation and inflation expectations.
There is always the possibility that markets are overreacting to the virulence of the coronavirus. Whatever failures in preparedness America has made, the virus is coming to our shores later in the year when the weather is warmer. Viruses typically lose their potency when the temperature rises.
Moreover, the U.S. population isn’t nearly as tilted toward vulnerable, heavy-smoking senior citizens as a nation like Italy or Japan. That’s one advantage. So is access to data from prior patient experience in other countries.
At some point when this is all over, pent-up demand could unleash a V-shaped recovery. If history is any guide, equities will have anticipated the rebound.
Retirement Planning Uncertainty
At that point, advisors are likely to be forced to address what is turning into a more permanent problem. Anyone confounded by equities in the last month might want to get a load of the bond market.
Absurd as it sounds, policy makers in Washington have become so addicted to artificial answers that many appear convinced monetary and fiscal policy can address a medical problem. That sent yields on 10-year Treasurys to as low as 0.6%. If the virus situation deteriorates further, some like Vanguard senior economist Andrew Patterson say it’s possible that markets could drive yields on these securities into negative territory, regardless of what the Federal Reserve does. In the corporate bond market, the day of reckoning has arrived, as high-yield spreads have widened dramatically.
That would be a huge problem for anyone trying to match assets against retirement liabilities, whether they are a financial advisor, pension fund manager or self-directed retiree. Unlike Europeans and the Japanese, most Americans retiring today don’t have pensions. If this scenario materializes and near-zero interest rates are here to stay, that could turn into a more challenging long-term problem than the virus.