Wednesday, February 26, 2020

A Viral Market Meltdown: Fear or Fundamentals?

It has become almost a rite of passage for investors, at least since 2008, that they will be tested by a market crisis precipitated sometimes by political developments (Brexit), sometimes by governments (trade wars), sometimes by war and terrorism (the US/Iran standoff) and sometimes by economics (Greek default). With each one, the question that you face about whether this is the “big one”, a market meltdown that you have to respond to by selling everything and fleeing for safety (or the closest thing you can find to it) or just another bump in the road, where markets claw back what they gave up, and then gain more. After yesterday’s global meltdown in equity markets, I think it is safe to say that we are back in crisis mode, with old questions returning about the global economic strength and market valuations. I have neither the stomach nor the expertise to play market guru, but I will go through my playbook for coping.

Start at the source
This crisis has an uncommon source, insofar as it is one of the few that is not man-made (at least based upon what we know now) and is thus more difficult to predict, in terms of how it will play out. As a novice in infectious diseases, here is what I know at the moment:
  1. The virus (COVID-19) had its origins in China, though what caused it to spread into the human population is still unclear and rife with conspiracy theories. In an attempt to keep the populace from panicking and to give the impress of being in control, the Chinese government initially went into crisis mode, trying to control the information that is being made public and that has created both confusion and skepticism about official claims.
  2. Within China, the virus has had its biggest impact in the Wuhan province, but it has affected other parts, though there is still not clear by how much or how many. The count, which is obviously a moving target, is that there are more than 80,000 cases of the virus, with more than 2700 fatalities so far. The latest reports from China is that new infections are falling, and if true, this would suggest that the spread is being controlled. 
  3. The most immediate spread has been to the neighboring Asian countries, with Singapore being an early casualty and South Korea a recent-add on. It has jumped borders and is showing up in more distant parts of the world, mostly in occasional cases. Over the weekend, though, the Italian government set alarm bells ringing with an announcement of a large cluster of cases in the country, which suggests that earlier assessments that the virus was not easily communicable may need to be rethought, and it was this news that seems to have precipitated this week’s sell off. On February 25, the CDC warned Americans that the disease could make significant inroads in the United States and suggested that states prepare cautionary measures.
  4. There is no cure or vaccine yet for the virus, but the mortality rate from the virus seems to vary across the population, with the very young and the very old being the most likely to die from it, and across geographies, with more deaths in Asia than in Europe or the United States. The overall mortality rate is low ( about 3%), but it is higher for people who are hospitalized with complications. 
In short, there is a lot more that we do not know about COVID-19, than we do, at least at the moment. While it has not been labeled a pandemic yet, it seems to have the potential to become one, and we do not yet have a clear idea of how quickly it will spread, how many people will be affected and what will push it into dormancy. It is also clear that much of this uncertainty will get resolved by real-time developments, not by collecting data or by listening to experts to tell us what will happen.

Get perspective
There is no denying that the last week has been a rocky one for investors, and a 1800-point drop for the Dow over two days (February 24 &25) is bound to add to the sense of foreboding. Since the first casualty of a crisis is perspective, it may be worth stepping back and looking at the market through wider lens. After the drop yesterday (February 24), the S&P 500 was at 3225.89, slightly above where it started this month (February 2020) at. In short, investors in the index were back where they were 18 trading days ago. Bringing in February 25 into the picture does put you below that level, but it still way above what it was a year ago:

In fact, extending the comparison to longer time periods only makes the hand wringing over the last week’s losses look even more absurd. This is both good and bad news. The good news is that, if you are a diversified investor, your portfolio should not look dramatically different from what it looked like at the start of the year and much, much healthier than it looked a year ago, five years ago or ten years ago. The bad news is that the big run-up in stocks over the last decade has left you exposed to more and bigger losses to come. The bottom line is that your concern should not be about the damage to your portfolio from the last week’s developments, but the damage that is yet to come.

Have a framework
With perspective in place, I am now in a position to look to the future, since that should govern how we react to last week’s developments. Given my investment philosophy of trusting fundamentals and value, I have to go back to my basic framework for valuation, which is to tie the value of an investment to its cashflows, growth and risk. When valuing the overall market, here is what it looks like:

With my value framework, the effects of the Corona Virus will play out in my forward-looking numbers in the following inputs:

1. Earnings Growth: Even at this early stage in this crisis, it is clear that the virus is having an effect on corporate operations. With some companies like hotels and airlines, the effect that the virus has had on global travel has clearly had an effect on revenues and operations, and it should come as no surprise that United Airlines announced, after close of trading on February 24, 2020, that it was withdrawing its guidance for revenues this year, as it was waiting for more information. With others, it is concern about supply chain disruptions, especially with Chinese facilities, and how this will affect operations in the rest of the world. The follow up question then becomes one of specifics:
  • Drop in 2020 Earnings: This is the number that will reflect how you see Corona Virus affect the collective earnings on stocks in 2020. This will include not only earnings declines caused by lower revenues growth at companies like United Airlines, but also the earnings decline caused by higher costs faced by companies due to virus related problems (supply chain breakdowns). The wider the swath of companies that are affected, the bigger will be the earnings effect. As to how big this effect will be on overall earnings, we can only guess, given where we are in this process. To provide some perspective, the 2008 banking crisis caused an earnings implosion, with earnings dropping almost 40% in 2008, from 2007, but the World Trade Center attacks in September 2001 barely made an impact on overall S&P 500 earnings in the last quarter of 2001.
  • Drop in long term Earnings: In previous crises, where consumers and workers stayed home, either for health reasons or because of fear, the business that was lost as a result of the peril was made up for, when it passed. If consumption is just deferred or delayed, the growth in subsequent quarters will be higher, to compensate for the lost business in the crisis quarter. If consumption is lost, the drop in earnings in the crisis quarter will never be made up. 
To illustrate the point, I look at how three different perspectives on growth will play out in growth rates, based upon how much of the drop in earnings this year is recovered over the following years:

Note that the first series is the unadjusted earnings, prior to the corona virus scare and that in all three of the scenarios, there is a drop in earnings of 5% in 2020, putting earnings well below expected values for 2020, but the difference arises in how earnings recover after that. If none of the drop in earnings in 2020 is recouped in the following years, the earnings in 2025 is 179.22, well below the pre-virus estimate of 199.28. If only half of the earnings drop is recouped, the earnings in 2025 is 189.41 and if all of the earnings drop is recouped, the earnings in 2025, even with the virus effect, matches up to the original estimates.

2. Cash Returned: In 2019, US companies returned 92.33% of earnings as cash to stockholders, with a big chunk (about 60%) coming from buybacks. That high number reflects not only the cash that many US companies had on hand, but a confidence that they could maintain earnings and continue to pay out cash flows. To the extent that this confidence is shaken by the virus, you may see a pull back in this number to perhaps something closer to the 85.24% that is the average for the last decade.

3. Risk and Discount Rates: Finally, the required return on stocks will be impacted, with one of the effects being explicit and visible in markets, in the form of the US treasury bond rate and the other being implicit, taking the form of an equity risk premium. If investors become more risk averse, they will demand a higher ERP, though as the fear factor fades, this number will fall back as well, but perhaps not to what it was prior to the crisis. The fact that the equity risk premium is already at the higher end of the historical norms, at about 5.50% on February 25, 2020, does indicate limits, but there could be a short-term jump in the number, at least until there is less uncertainty.

Using this framework on the S&P 500, you can see how each of these variables play out in value.
I am not an expert on infectious diseases, and the health and economic impacts of this virus are likely to play out as developments in real time, requiring that I revisit this framework frequently. Based upon my estimates of how this virus will affect the numbers, the value that I get for the index is 3003, about 4.14% less than the index level of 3128.21 at the close of trading on February 25, 2020, which, in turn, represents a significant drop from the level of the index a week ago. To the question of whether a virus can cause this much damage to the markets, the answer is yes, though whether it is an overreaction or not will depend on how it plays out in the numbers. For the moment, though, if you are tempted to buy on what looks like a dip, I would suggest caution just as I would argue for slowing down to someone who wants to do the opposite and sell. As you look at my assumptions about how the virus will play out in earnings (both short term and long term), cash flows and risk premiums, some of you may disagree (and perhaps even strongly) and you can use this spreadsheet to arrive at your own valuation of the index, and use it to drive your actions. 

To thine own self, be true...
It is entirely possible that I am underestimating the impact of this virus on economic growth and earnings and that I should be panicking more, but it is also plausible that I am over adjusting my numbers too much. The bottom line with my calculations is that I am inclined to do very little, at the moment. I don’t feel the urge to buy the market, because there is a plausible case to be made that the adjustment in value, steep and sudden, was merited. I feel little need to sell either, because I don’t see an over valuation large enough to trigger action. As for whether I should be reducing my exposure to companies that are directly affected by the virus (hotels and airlines) and increasing my exposure to companies that are more insulated, I don’t believe there will be any segment of the market that is fully protected from the consequences, no matter how far you get from China and from travel-oriented companies. In fact, if there is a segment of the market where you are likely to see over reaction, it is likely to be in airline, travel and energy stocks, precisely because they are in the center of the storm. Do I now wish that I had bought Zoom before this crisis reached full blown status? Yes, but I am not sure buying it now will do much for me. I am loath to offer advice, but my only suggestion is that rather than listen to the experts on either side of this debate tell you what to do, you should make your own best judgments, recognizing that they can and will change as more facts emerge, and act accordingly.

YouTube Video


  1. Spreadsheet to value Corona Virus Effects on S&P 500 (February 25, 2020)


nobleyu said...

hi, professor.

Where is 150.50 (Dividends plus Buybacks (base year)) from?

I can figure out you get "Base Year Earning 163" from the "Earnings History" sheet, but where is the number 150 comes from?

Hallbjorn said...

This is a great article as always and thanks for putting a calm air on the issue! I believe though that the economic effects will be greater than affecting earnings declines in ways resembling previous events, like e.g. 9/11. The main unknown here is how widely the virus will spread and what effects this will have if it spreads widely. The CDC has warned that the likelihood of the virus spreading “within communities” is very high. The CDC has to phrase their communication in such a way as to limit the risk of a panic, so their statement is significant. Adf

IF the virus spreads within communities, it will have large effects, something like we have not seen in modern times. The mix of high infection rates combined with a too-high death rate of around 2% is bad. We tend to discount what happens “far away”, but in China this virus has had a major effect on all normal business activities for weeks and months now. The Hubei province has 60m inhabitants, about the same size as the UK, and everyone there has been confined to their homes since January. This means small businesses far beyond travel and hotels feel a massive cut in revenue. Few businesses or individuals can tolerate halting business for extended periods of time. This virus behaves “slowly” in that it takes days if not 1-2 weeks for infected people to show symptoms, while 80% of infected individuals show no or little symptoms. The bottom line is, if the virus spreads, that it will take quite a long time for it to filter through the system and the economy.

I hear that smaller online platforms than Zoom, like (enables specialists like psychologists to service their clients online), are seeing a big uptick in sign-ons. Both these developments imply that well-informed specialists are ahead of the market in realizing the need for being able to service clients online before what looks now like the CDC has warned, that the virus will spread within communities and that it is highly unlikely that this can be avoided.

This mix, the effects of the virus with the market being near all-time highs at the same time, means the likelihood of the market going down is much greater than it advancing in the next few months at least. Your calculations on the effects are fantastic, trying to base decisions on hard numbers rather than feelings. Thanks!

Anonymous said...

Dear Sir, to have a proxy of how Covid-19 will develop, we can maybe have a look at its predecessor - SARS. In the timeline of events provided by WHO; "Update 95 - SARS: Chronology of a Serial Killer", the spread and development of events during the SARS outbreak was well documented. The saying, “History doesn't repeat itself but it often rhymes,” is rather true here in my own opinion. Link:

Unknown said...

In prior events (years ago) the stay at home situation did impact businesses because the workers were gone. With the tools we have today, being at home is just working remotely (for a lot non-factory/non service) which in come cases is more productive (less interruptions - debatable I know) then being in the office. I would think the Impact is less for a portion of the population. Are there any studies about the population percentage or estimates to show the reduction of expected impacts over previous years? A large percentage of the working population now has the remote work capability if companies implement that - at least for this event period. Thank you for the great article above. Good luck to all of us and those impacted by this virus beast.

dsf said...

Hello Sir,
A very well written article explaining the unexplained. I was desperate to take a decision seeing the mayhem around. But Thank you for driving the point through me that sometimes no decision is also very good. A big Thank You!