Feb 27, 2020

In yesterday’s post, I pointed out that the markets were taking a break, stopping the sudden slide to think about whether the news surrounding the coronavirus is really as bad as all that. Today, they appear to have decided that, yes, things are that bad and may be even worse. Perhaps, then, it is time for me to reassess my conclusions.

Indeed, I have had some feedback suggesting that I am “dead wrong” and will “eat my words.” Fair enough. Those commenters may be right. The thing is, that is always the case. Any time you make a call, on the best data and analysis you have, you could be wrong. Nothing new here.

Are the facts changing?

As the virus continues to spread, new information about the economic impact comes in, and the markets continue to slide. It makes sense to take this new information into account. A famous Keynes quote is especially apropos here: “when the facts change, I change my mind.” So, are the facts changing?

Short-term risk. One significant fact is. I said yesterday that I use the 200-day moving average as a rough and ready guide to when to pay attention—and the S&P 500 cracked that level earlier today. It has since recovered a bit, but risks of a deeper decline are clearly building. The short-term risk profile has definitely risen.

Long-term risk. The longer-term risk profile, however, has not risen. There are a couple of ways to demonstrate this idea. One is to look at subsequent returns after a pullback like the one we are having, which I covered yesterday. Another is to evaluate how interest rates—a very good proxy for investor fear—behaved in previous epidemic situations.

Lower interest rates on U.S. Treasury securities typically follow increased investor fear. The more fear, the more investors want low-risk securities and the more they will pay for them, lowering the effective rates. The chart below shows the drop in interest rates during previous epidemics and during the current one. It illustrates that we are close to the point of peak fear where previous epidemics bottomed. In other words, this may be close to as bad as it gets.

Source: Wall Street Journal Daily Shot

Is this as bad as it gets?

When we look at the new case data, that conclusion seems reasonable. Cases in China peaked a couple of weeks ago and have continued to decline. Despite a slower-than-expected economic recovery, the Shanghai Stock Exchange Index has largely bounced back. Big picture? In China, there is reason to believe the epidemic is being brought under control and that even though the economic damage is real, it is limited. Markets are moving back up as that picture becomes clear. China seems to be behaving just as this chart would suggest.

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