Did stocks tank on Monday because they were finally noticing danger signs that the bond market has been screaming about for weeks? Or did equities just react in a reasonable way to the rapid spread of Covid-19 in South Korea and Italy over the weekend?
The answer matters because overexuberant shares tend to fall further and faster than they otherwise would. That means the virus-induced stock selloff could turn into a nasty recoupling if there was an irrational divergence between bonds and the stock market.
Bears have been arguing for weeks that stock markets have diverged from bonds. Stocks also seemed to separate from other assets as the U.S. and European markets hit new highs up to last Wednesday. The havens of gold, bond prices—which move inversely to yields—and the dollar were up while economically sensitive industrial metals and crude oil prices tumbled. Stocks are risky assets, and usually fall when there is a search for safety, so this performance was odd.
Yet, look below the surface of the S&P 500 (.SPX) and the market mostly reflected investors’ concerns: Defensive stocks able to ride out a weak economy did well. Economy-exposed cyclical stocks did badly. The strong performance of technology stocks messes up many assessments, but even that has some justification.
Consider three pieces of evidence. First, many sectors of the market did precisely what one would expect. Even before Monday’s plunge, the energy sector was down 8.7% including dividends from Jan. 20, the day human-to-human transmission of the new coronavirus was confirmed. The commodity-sensitive materials sector was the next-worst performer, although down only 1.2%. Meanwhile, utilities and real estate were both up more than 5%, benefiting from lower bond yields and their status as bond alternatives. Stocks with reliable dividends also did well, aside from the horrible performance of major oil companies Exxon Mobil (XOM) and Chevron (CVX).
Underperforming the market, and falling a little, were the industrial and financial sectors, sensitive to the global economy and interest rates. The dull consumer-staples sector beat the market, as it usually does in bad times.
Out of place was the better performance of cyclical consumer-discretionary stocks, up 2.6%, which seems odd until you realize that Amazon.com (AMZN) is almost a third of the sector. Strip it out, and the rest fell on average almost 4%, exactly what should be expected as concerns about the new virus grew. Amazon is treated by investors as a technology growth stock, and tech is the sector that doesn’t neatly fit the normal cyclical-defensive split. Tech was still up 2.2% by Friday’s close, ahead of the market, before falling hard on Monday.
This brings us to the second piece of evidence: duration. The longer in the future that profits are likely, the more sensitive a stock should be to bond yields, as a proxy for the rate at which future profits should be discounted back into today’s valuation. The lower the rate, the higher the current value of future profits.
Of course, this is true only all-else being equal. Rates will be lower because the economy is expected to be hit by the virus, which also means lower profits.
But for the fast-growing companies where much or all of their value lies in their hoped-for dividends far in the future—Amazon and Netflix (NFLX) are leading examples—worry about a temporary, contained outbreak was more than offset by lower bond yields. These sort of “growth” companies soared above cheap “value” stocks as bond yields fell, and the tech sector has a lot of them. Meanwhile, mature tech stocks paying higher dividends than the S&P on average fell almost 3% from Jan. 20 through Friday, because they don’t have the long-duration growth to offset the Covid-19 damage.
Finally, the credit markets have been telling the same story as the equity markets: an expectation of a contained outbreak, not something that will cause a recession or crush the weakest junk bonds.
Yields of the lowest grade of junk, CCC, rose from 9.6 percentage points above Treasurys to a peak of 10.6 points in the late-January panic, but came back into just 9.8 points by Friday. This rise in the spread was smaller than the drop in Treasury yields, so the CCC yield on Friday was slightly below where it was on Jan. 20, according to the ICE BofA index. These are the companies most likely to fail in a recession, so their resilience suggests little investor fear.
Put it all together and it looks like investors shifted over the weekend from a belief in an economy weakened a bit by coronavirus problems in China to growing concern about a much more serious global problem. This really matters, both for human health and stock prices. But it is a reasonable response to the news about a hard-to-predict viral outbreak.
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