The Coronavirus Column, Part 2

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

A Rough Ride Last Tuesday's column suggested that the S&P 500's troubles might extend. Usually when stocks drop sharply over a short period, as they did during the final week of February, they subsequently recover and the event is quickly forgotten. For example, few today recall that U.S. equities lost 8% over the first two weeks of 2016, and fewer yet recall why. (Not I.) However, this time seemed different.

Boy, howdy, has it been! Contemporary readers need no recap, but for those perusing at a later date, over the past seven days--

1) The number of quarantined people in developed countries ballooned from a few thousand to 16 million.

2) In the United States, schools began to shut down, and several major events were canceled. For example, the city of Austin shuttered an annual festival that generated an estimated $355 million in spending last year.

3) Consequently, the betting odds that the United States will suffer a 2020 recession spiked to 65%.

Adding to the turmoil was a single-day decline of more than 15% in crude-oil prices, courtesy of a price war between Saudi Arabia and Russia. The upshot: Stocks have fallen another 8% since last week’s column was published.

Strange Days Ahead I foresee further turmoil, for several weeks if not months. Mind you, I am not predicting a prolonged bear market, although such an outcome would not surprise me. Forecasting stock prices is beyond my pay grade. What I am comfortable in prophesying is that volatility will remain high. Uncertainty breeds stock market gyrations, and today's climate is nothing if not uncertain.

The shoes will continue to drop. Each week will bring fresh information about the spread of the coronavirus, its effects, and potential treatments. There will also be additional quarantines, perhaps massively so. Such items cannot be predicted with any level of accuracy and therefore will jolt equity prices as they arrive.

The economic news isn’t any easier to divine. Forecasting recessions is a difficult task even for slowdowns that occur for the conventional reason that the business cycle has become overextended. Anticipating a downturn caused by artificially restricted consumer demand is harder yet. Also, the usual countermeasure for slowing demand--lower short-term interest rates--is largely irrelevant if the cause is a pandemic. After all, easy money won’t induce people to book more flights.

The economic situation is beyond unusual; it is distinctly odd. Typically, reduced consumer demand leads to lower spending in cyclically sensitive industries, such as automobiles, and flat spending with evergreen sectors like breakfast cereals or heart medications. (Few firms outright grow their sales during slowdowns. For example, despite a popular myth to the contrary, Hollywood film revenues fell sharply during the Great Depression.) Not so today. Some businesses will be big losers, while others figure to prosper.

Specifically, businesses that require people to gather in a group or that benefit from travel are at great risk. Airlines, cruise ships, hotels, convention centers, and restaurants would be prime examples. On the other hand, Amazon.com AMZN (which would scarcely seem to need the boost) will receive all the orders that its trucks can deliver. Far better to serve customers individually, at a distance, than to engage them closely.

Many Questions, Few Answers As with any slowdown, there will be knock-on effects, as one domino sends another tumbling. The longer that process, the longer the volatility will persist. The 2008 stock crash, for example, was prolonged because the financial contagion (so to speak) spread from subprime real estate, where it started, to conventional real estate, to the banking system, to the automobile manufacturers. The links in the chain were not evident at the beginning, but they were by the end.

In short, the stock market will be drinking from a firehose of information, adjusting prices along with each new data point. Such movements are not necessarily irrational. Often, they are the investment equivalent of thinking out loud, as shareholders incorporate the news by making flurries of trades. The process is messy but sensible.

However, I do confess to wondering about the sanity of yesterday's stock markets. For one, it puzzles me that global equities fell sharply on news of the Saudi-Russian tiff. Slumping oil prices can be expected to stimulate the global economy, not constrict it. Did investors panic upon hearing about yet another surprise and place sell orders before thinking through the full implications?

The relative performances of the world's bourses were also confusing. Equities of the world's second-largest exporter, Russia, lost 5%, as did those of Japan, the fourth-largest importer. Similarly, German, French, and British equities fell further than did securities listed on the Toronto Stock Exchange, although the former countries are oil consumers, while Canada exports more oil than any nations save for Saudi Arabia, Russia, and Iraq.

One can't interview stocks to ask them why they traded as they did. There may be sound reasons why: 1) oil prices plummeted, 2) stocks followed suit, allegedly partly as a reaction to the oil-price shock, yet 3) countries and businesses that consume oil didn't perform notably better than those that produce and sell oil. The suspicion arises, though, that the weekend's decline in oil prices was one bombshell too many for global investors.

If I ran an equity fund, I would seriously consider buying stock market put options to guard against the possibility that this year will prove to be 2008 revisited. Of course, market puts cost far more than they did one month ago, so their prices might dissuade me from taking that action. But I would at least investigate the tactic.

Since starting this column in spring 2013, I had not before entertained such a thought.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.