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Coronavirus Disrupts Bull Market



KEY POINTS:

  • Market fizzles as Coronavirus interrupts the charging bulls. The S&P 500 ended the month at 3225.52, down -0.16%. The Dow Jones closed at 28,256.03, in January, and it was also down -0.98%.

  • Coronavirus scare has jumped to the forefront of all news as cases and deaths rose quickly. China shut down half of its country to attempt to quarantine people and limit the spread of the virus.

  • Utilities, Technology and Real Estate led all sectors in January.

  • Mid-Cap stocks were down -2.7%, while Small Cap stocks fell -4.0% in January.

  • Bond market yields fell as the 10-yr. fell to 1.51% sparked by the global virus fears and market sell-off.

  • European and Emerging Market stocks suffered even more mostly due to virus fears. Europe was down by -2.2% (Dev. Ex-US) and Emerging Markets were down -4.3% with China leading the region lower.

  • Traders and investors were looking for a “reason to sell” after a three-month surge in the S&P 500.

  • Markets and the news cycle forgot about the tensions with Iran over the death of General Suleimani.

  • PE (P/EPS) ratio for the market continues to hover at the upper range of normality as everyone awaits a better earnings season so the “E” will get higher, allowing the PE ratio to avoid overvaluation fears.

  • Risks for 2020 have shifted slightly with the virus taking center stage as we consider what the fallout will be not only to loss of life, but also earnings as most of China was shut down. The Fed, interest rates and tariffs will always remain in the backdrop as major risks that could derail the market.

  • Earnings growth will be the key catalyst for the market to head higher.

  • We continue to project earnings growth to fall within 5-10% with Q1 maybe looking weaker now as we try to figure out the damage from the disruption to business from China.

  • Likelihood for a pullback of 5% or more is growing as we expect to see one in the next 3-6 months. One reason for the delay is the addiction to liquidity and low rates that the Fed, and all central banks, are peddling to all stock markets.

MARKET SNAPSHOT


The first three weeks of January seemed like the market fiesta would never end as the S&P 500 surged 14.9% (chart B), from the close of Oct. 8th until the 23rd of January. Bulls were still popping champagne as the tariff feud was nowhere to be seen and the low rate, “liquidity-flooded” environment was providing fuel for this skyrocketing market. Then the Coronavirus arrived in China and the most populated country in the world had to shut down half of the country and quarantine individuals in many regions. This slammed the door shut on the early 2020 market rally as investors were seeking for a serious reason to take off some gains.


We started the month thinking that Mideast tensions would escalate after the kerfuffle with Iran and now most of the world is looking around to see if anyone is sneezing near them. All jokes aside but this threat is real and very serious. We must appreciate that China jumped on this crisis quickly and shut down large epicenters, like Wuhan, where the virus supposedly began its incubation. Wuhan has 11 million people and to make things worse this was the start of the Lunar New Year where factories and businesses shut down as workers traveled back to home regions to celebrate. Another fear was as the number of infected individuals and deaths increased sharply, the stock market (Shanghai) was closed for one week for the New Year, which is typical. We all awaited the opening of the market this past Monday, with much anticipation on Sunday night (Shanghai open) as we were flipping TV channels between the Super Bowl and Bloomberg. During the day, on Sunday, the Dow Jones futures were pointing to a -600-point drop on Monday and a -10% fall on the opening of the Shanghai exchange. But as the opening of the market neared we saw unusual movements in the U.S. futures as they surged positive as it was uncovered that the Chinese government was flooding its markets with roughly $120 billion of stimulus and emphasizing that they will do anything possible to maintain stability. They also reported that no large sell (>10%) trades would occur for several days unless they were approved by the government. One good reason to have a Communist government with this reach into every area of the country. This calmed all U.S. investors as the threat of a sharp drop in the U.S., on Monday morning, was eased. We can definitely say that the liquidity injection was important, but it just continues along the same global theme that central banks have been following for many years as they feed the addiction of markets with excess liquidity. In this case we can say it was really needed. But this does not solve all of the problems that we might foresee in the near term. Of course, we hope the virus is contained and we are seeing new infections easing up. But you had half of China closed meaning also U.S. companies were closed and that also means supply chains coming out of China are affected. This could present a big problem when Q1 earnings start as we have no idea what they might look like. We expect a possible 1.0-1.5% drop in the GDP of China (6.0% in 2019). The U.S. could also see a 0.25%-0.35% drop in GDP as we try to stay above 2.0%. But the U.S. market surged this week as if nothing was happening globally as hints of a possible Fed rate cut (Sept.) inched up to 70%. We are hoping that even with a shortfall in Q1 earnings, we can achieve the 5%-10% projected earnings growth for this year. This will help the S&P 500 close above 10% for the year. If earnings growth falls below 5% this year, market returns will not reach 10% as valuations will be too high and you see investors and algo’s selling. We also believe there is a greater probability of a 5%, or greater, pullback for the first half of the year, versus an increase of the same magnitude, as we unravel what the damage will be to earnings from the closures in China.


CHART A: S&P 500 (Jan. 2020)

Source: AETOLIA CAPITAL & KOYFIN

CHART B: S&P 500 (Jan. 2020)

Source: AETOLIA CAPITAL & KOYFIN

S&P 500


The S&P 500 was having a terrific January as we stated above until the virus disruption. The index ended the month down -0.16% after rising over 3%. The breadth of the market is still showing that it wants to go higher as long as earnings come in as predicted. Besides an earnings growth miss, another factor that could put pressure on the index is a further catapult of a more progressive-leaning candidate for the Democratic party. After the disastrous Iowa caucus, we saw that Sanders and Buttigieg led all Democrats as they head to New Hampshire (NH). Biden’s fourth place finish was disappointing and if he does not do well in NH, Nevada and South Carolina you are likely to see him dropout as capital is running thin. On the other hand, Bloomberg is pouring his billions into advertising and has not been tested yet. If Biden leaves, then that will leave Bloomberg as the only valid moderate candidate, that the market would like to see running against Trump. Any other nominees besides Biden and Bloomberg might be met with market weakness until we get closer to the election.


In the past few days we are also seeing an uptick in the probability (70%) of a rate cut in September by the Fed. This goes along with the liquidity injections we spoke about in our last email, as the Fed is purchasing short term debt. This liquidity has been fueling our market since October. Now add the recent liquidity in China and you get a clear understanding why markets, globally, rebounded so quickly after the initial selloff caused by virus fears.


If we look at the technical chart of the S&P 500 (chart C), we had a major breakout starting in early October that surged 14.9% until we slammed into the virus fears on Jan. 23rd. We see a first level support level at 3212 that we bounced off of several times in January. Now the market is coming up to its all-time high of 3329, where we might test that level a couple of times until the market feels justified to break higher. Obviously, further good news about virus containment and less predicted fallout in earnings should boost the market to new highs, as Q4 earnings have been good so far.


CHART C: S&P 500 (2-year)

Source: AETOLIA CAPITAL

10-year Treasury yield (5-yr. chart)

The 10-yr. rebounded off the lows of 2019 and headed higher as the tariff news got better and the breadth of the market strengthened. It started to tick closer to the big 2.0% line, but the recent virus pullback heightened the fears of investors as they sought coverage causing the 10-yr. to inch closer to its 2016 low of 1.38%. It ended up in the 1.5% range and has recently pushed higher in the past few days. We expect it to linger in the 1.45-1.65% range until all worries about the virus have surpassed. We expect the 10-yr. to end above the 1.80% level, but not surpass 2.0% until possibly next year. Of course, any new unforeseen risk can push it lower as investors seek our U.S. treasuries.


Source: AETOLIA CAPITAL & KOYFIN

If you have any questions or comments, please contact me.


Regards,

John Anagnos

Managing Principal

Chief Investment Officer

AETOLIA CAPITAL LLC

3828 Kennett Pike

Suite 212

Greenville, DE 19807

Office: 302-543-4446

john.anagnos@aetoliacapital.com

www.aetoliacapital.com


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MARKET INSIGHT