The major indices are clearly taking the coronavirus more seriously now, with the S&P 500 selling off by 3.4% on Monday, after seemingly ignoring the threat previously as the indices marched to new high after new high.
The virus, known as COVID-19, has proven more difficult to contain than previous health scares such as SARS. No one can predict such events and their outcomes will depend largely on the strength of the economy—much like recovery from a virus depends largely on the individual’s overall health.
Rarely do events such as SARS and COVID-19 cause long-term economic deterioration. To be sure, it can be painful in the interim. For example, Apple issued guidance that it will not meet its revenue projections for the Q2 of fiscal 2020 because of supply-chain disruptions in China that are taking longer to normalize. Increased market volatility is to be expected; but, in my view, there is a high likelihood of a meaningful recovery in a reasonable amount of time.
As I have said many times before, if the economy is growing above the long-term trend, the outcome of an event that cannot be predicted, forecasted, or prepared for will have a different outcome than if the economy is at or below trend. Currently, the economy—as captured by the Astor Economic Index® (AEI)—is near the lowest levels seen in many years. Nonetheless, economic growth is still occurring at levels we believe suggest a positive expected return for risk assets such as stocks in the near-term.
Source: Astor, BEA 12/31/1998 – 12/31/2019
COVID-19—What the Data Say
Understandably, COVID-19 is causing anxiety and uncertainty. Amid such fear it’s important to take a data-driven approach. As the chart below shows, the COVID-19 (SARS-CoV-2) fatality rate is slightly above the seasonal flu, and its contagiousness is also only slightly higher. Of note, the fatality rate is highest among older, sick, and weaker individuals who contract the virus, whereas healthier, younger people generally recover in a similar way as from the seasonal flu.
*The averages of fatality and reproduction rates are used here. For polio and measles, data is from 2018. For smallpox, data is from the last 100 years of its existence. Source: WHO, CDC, NYT; Investment Strategy Group.
Human suffering cannot and should not be minimized. But looking at the data objectively, a parallel can be drawn between COVID-19 and its impact on people, and unforeseen events that have hit the economy in a flu-like fashion. In the past several decades, many events have occurred that caused market disruptions and drawdowns but were followed by a quick bounce-back.
For example, in 1987, a rapid decline in equities was caused by liquidity issues and the explosion in new products such as portfolio insurance. However, the economy was strong in 1987 with growth rates well above trend. Investors may not recall the details now, but the S&P 500 finished positive on the year and fully recovered from the drawdown in the following 12 months.
The savings and loan crisis had a similarly material impact, with increased market volatility. Once again, it occurred at a time when the economy was growing at-trend, and market deterioration (or wealth destruction) was limited. Recovery occurred within a reasonable timeframe.
The financial crisis of 2007-2008 was a different scenario. The economy had started to slow, and Fed activity was counterproductive. Therefore, the crisis in real estate lending, subprime mortgages and derivatives had a much more significant impact. These derivatives had caused some wealth destruction before; but when economic growth rates fell to the trend line and then below trend, the markets crashed, and wealth destruction was rampant.
In Q4 2018, the stock market sold off at a time when the economy was growing well above trend. Although I still cannot fully cite the reason for the quick drop (even though there are many to blame), it was followed by swift recovery.
Where Are We Now?
The current AEI reading (the “now-cast”) confirms the economy is still growing at trend. At Astor, we continue to keep a close watch on the economy with up-to-date analysis of the data.
However, it’s interesting to note the concentration of equity indices that have been making new highs—Dow Jones Industrial Average, S&P 500, and Nasdaq Composite—are very popular among passive investors. I believe it is good news when the most popular indices are also the best performing indices. However, I can foresee a problem if and when the economy drops below trend and unexpected events hit the economy. When that occurs, these same indices will likely underperform.
I can envision a scenario where the herd mentality among passive investors leads them to get out of the same indices. As everybody rushes to the exits at once, it’s easy to imagine how messy things could get. And with a passive investment strategy, there’s no one calling to talk about what is really going on—whether something is a momentary dislocation or indicative of fundamental weakness.
A tip of the hat to active management being the timely choice. Active management has an investment thesis behind it. For us at Astor Investment Management, our investment thesis is based on fundamental analysis of the economy, using a “now-casting” approach to determine the current strength or weakness of the U.S. economy.
It’s a data-driven approach that cuts through the noise, fear and uncertainty.
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The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points, including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. There is no guarantee the Index will produce the same results in the future. All conclusions are those of Astor and are subject to change.