The Great Repricing

The spread of the novel coronavirus, officially COVID-19, in Italy and South Korea over the weekend was a wakeup call for the markets. And an ugly one. This week is shaping up to be one of the heaviest percentage losses in recent memory. Tuesday and Wednesday saw failed rallies, and yesterday, Thursday, the Dow was off over 900 points at 10:30 am, then retraced over 750 points in a two-hour rally, before falling 500 points in the next two hours. By the end of the day the index closed down just shy of 1,200 points. Stock futures are signaling a lower open again today.

If you are a daily market watcher, I hope you have a supply of Dramamine close at hand. Have the markets suddenly gone crazy? What is happening?

While it may look crazy and random, the volatility, and the overall decline, is evidence that the markets are doing what capital markets are supposed to do: assess and price risk. What we are seeing this week is a great repricing event, and right now, the markets are struggling to find a stable price level. It’s ugly. It’s scary. But it is what markets do, and it is ultimately the sign of a healthy market reacting to unhealthy economic conditions.

Shares in a publicly traded company are, at their essence, rights to future earnings of that company. For this reason the price-to-earnings multiple is a core metric for stock evaluation. What we are seeing in graphic detail this week is what happens to the markets when future earnings have a greater level of uncertainty. I may think next year’s earnings for company Z will come in at $1 per share, and I’ll pay $20 for that (hopefully) growing earnings stream. Another buyer may be willing to pay $22 for that stream, thinking that the earnings will grow faster than I believe. Or perhaps they think the $1 estimate is low and their analysis tells them it will be $1.10. It’s complicated, and markets move quickly, at times erratically, and on a daily or weekly or even monthly basis, not particularly efficiently. Over time, though, the ups and downs smooth out and markets are efficient over a multi-year cycle – earnings move up and prices do too. Some companies fail to grow, their earnings fall, and so do their share prices. A new company comes on the scene and grows massively, and everyone wants to buy a piece of their future. And the cycle goes on.

Efficient pricing depends on reliable forecasting. The future is never known, but the more accurately it can be predicted, the less severe the short-term ups and downs may be. Right now, markets can’t agree on what the most likely economic impact is, and the range of plausible impacts is huge. What we know about COVID-19 is that it has ground commercial activity to nearly a halt in the second-largest economy in the world. That same economy provides a very large share of the world’s collective economic growth. Fortunately, in normal times (but unfortunately now), the world economy today is more integrated than ever before, taking advantage of comparative advantage to produce goods and services in the most efficient way possible and transporting or transmitting those goods across the world. In South Korea, the largest auto manufacturing complex in the world, Hyundai/Kia’s Ulsan complex, was idled three weeks ago, not because of the dangers of coronavirus, but because they ran out of wiring harnesses that are manufactured in Hubai province, the epicenter of the outbreak in China.

How long will China be idled? The government there is working hard to restart commerce. Until last week, the markets were heavily discounting a sizeable impact beyond one quarter, preferring instead to believe that that lasting impacts would be minimal. I thought that was overly optimistic, and I said so on CNBC’s Halftime Report on February 13. The esteemed traders on the desk all but laughed at me. (There is a link to the segment in the right margin of the newsletter if you would like to see.)

The expansion of the epidemic to Italy, and specifically the industrial heartland of Lombardy, as well as the rapid spread in South Korea, created new uncertainty in the markets. The economic impacts will be greater than initially thought. The rapid spread of the last few days has told us something else very important: we really don’t know how big those impacts will be. To be sure, the virus might be effectively contained and diminish. China and South Korea may restart manufacturing production seamlessly, and supply chains could refill with little interruption. If so, the overall impact could be a “blip” in the statistics for the first quarter. I don’t think it will be nearly that easy. We could see an expanding pandemic that seizes supply chains for the better part of the year, shuts down transportation and closes companies across the globe (and yes, here in the US as well!). The world could fall into a recession. I don’t think it will be that apocalyptic, either, but the point is that neither I nor anyone else knows.

What I do know is that we at Farr, Miller & Washington have endured tough economic times in the past. We have researched our investments and always questioned, “how will this fare in a ‘worst-case’ scenario?” We are firm in our belief that a discipline of investing in companies with strong balance sheets and proven management teams will serve us well in times like these. Companies with “rainy day” cash to endure downturns and recognize opportunities in turmoil have the potential to take market share over a five-year, ten-year, or longer timespan. We work with our clients so that the risk level in their individual portfolios is appropriate to their needs, their time horizon, and their investment goals. Above all, I know that our professionals will diligently work for our clients’ best interests, no matter whether the future brings a violent tempest, or merely a passing shower.