Summary

• The S&P 500 can drop another 25-35% yet, so tread carefully.
• Use any rallies to sell “old economy” disrupted assets.
• Use the deep corrective valleys to load up on “new economy,” “smart everything world,” 4th Industrial Revolution, alternative energy and a few resource assets.
• Patience is a virtue, but it’s too late to be scared, start thinking greedy so you are ready to pull the trigger as the times to do so come.

The Coronavirus Covid-19 is a human tragedy that is likely to hit the United States imminently. All of our hearts bleed for those affected and we wish for the best possible health outcomes.

If you are up to date in reading my 2020 Outlook: Euphoria To Despair, Expect Major Stock Market Challenges In 2020 and Coronavirus Is A Match That Lit The Overvaluation Tinder, then you are aware that I was cautious coming into 2020. Among things I was concerned about was “an early bought of volatility akin to early 2018.” Coronavirus has brought about that early bought of volatility.

While it is almost never possible to know what match will light a volatility fire, there is quantitative data that can tell us when an event is more likely. So called “black swans” such as Coronavirus are not knowable ahead of time. Only the conditions are knowable. In this weekend’s webinar, I talk about some of the knowns and unknowns:

Disease X Was A Known Probability

For years, we have known a “Disease X” was not only possible, but likely, to cause a pandemic. Health organizations have been tracking diseases related to coronaviruses since the SARS epidemic in 2003. I have been loosely following the research for over a decade now.

Since I have been following disease outbreaks and potential disease outbreaks, it has become clear to me that economies and markets around the world are completely underprepared for such events. What has made it worse in the United States is that critical programs and people who track and fight disease were defunded and fired in the past 3 years. That leaves the United States particularly vulnerable given the amount of travel that Americans do.

On January 23rd, when I saw the first news of Coronavirus hit, I know it would be a serious situation. On Jan. 23, I stated on my Twitter feed that Coronavirus “is actually the most important story in the world…” Since then, the Coronavirus COVID-19 outbreak has become the volatility event that’s driving what was an inevitable and necessary stock market correction.

Epidemic Bringing Valuations Down

At this point, Coronavirus is an epidemic, but has the potential to be a pandemic. What is the difference? According to the Centers for Disease Control and Prevention:

Epidemic refers to an increase, often sudden, in the number of cases of a disease above what is normally expected in that population in that area. Outbreak carries the same definition of epidemic, but is often used for a more limited geographic area. Cluster refers to an aggregation of cases grouped in place and time that are suspected to be greater than the number expected, even though the expected number may not be known. Pandemic refers to an epidemic that has spread over several countries or continents, usually affecting a large number of people.

A pandemic would clearly be more severe on a human scale. It would also have a more severe impact on the global economy and markets. A pandemic could erase years of stock market gains.

If you are following my articles and reading the quarterly letters, then you know that valuations were a large concern of mine in the past six quarters. High stock market valuations make the stock market more risky and more susceptible to shocks. Coronavirus is a very significant shock.

High Valuations Were A Warning

I have discussed for six quarters now that stock market valuations were very high. A single-digit percentage stock market correction has not changed that.

Jill Mislinski

An argument is often made that because interest rates are low, the stock market can sustain higher valuations. I would agree that is true, however, to what degree should be asked. Should the stock market be the third most highly valued in history?

The chart above shows that despite low interest rates heading towards zero, corporate profits haven’t been growing much the past several years. What we have with low interest rates is a period of diminishing marginal returns.

Given that the stock market is a forward looking projector, what happens when lower interest rates or monetary stimulus cannot push corporate profits higher? What happens when businesses simply cannot borrow more for almost free to improve profitability via production or share buybacks? Clearly that challenge already is manifesting.

Creative Destruction

If you believe that a stock represents the value of an underlying business, I point you to the Q Ratio. That’s total market cap divided by its replacement cost. Essentially, if you are a business person, here’s when you ask: Should I make an investment in the stock of a business or should I simply start a competing business?

The obvious answer for a business person seeing these valuations is to start a business and compete, rather than buy highly-priced stock. What do we know happens when more competition is introduced to a market? Prices fall.

I understand this is a simplistic way of looking at this. We are not going to see thousands of new businesses sprout up to compete, but we are seeing some. And these new businesses are in fact disruptive of many of the older businesses.

Consider the concepts of creative destruction. Think about the unicorns and all the disruption industries are seeing from tech innovation. At some level, perhaps how entrepreneurs get financing, high valuations are in fact encouraging competition to established players already in the market. That can’t be good for many companies or their stock prices.

As Stanley Druckenmiller said a while back: “Buy the disruptors, sell the disrupted.” We’ll come back to this thought below.

Warren Buffett’s Favorite Indicator

Now that everybody has gotten a chance to read Warren Buffett’s annual letter, let’s take a look at his favorite valuation metric for the broader stock market: The ratio of total market cap and U.S. GDP.

Mislinski with Spano annotations

In that chart I stake out the “old normal” for valuations and a hypothetical “new normal” based on lower interest rates and looser monetary policy. In either reality, the stock market has a long way to fall. I would suggest that we should consider it might fall to the place where the old and new normals overlap. That would imply a 30%-40% stock market correction is on the horizon.

The Shiller PE Ratio Projects Low 2020s Returns

Many people criticize the Shiller PE ratio as unimportant or wrong. That’s a juvenile misunderstanding of what the ratio is. It’s not a short-term oscillator or predictor of imminent stock market movements. Rather, it’s an indicator of expected stock market returns on a normalized basis over the next 10 years based on the last 10 years earnings.

Because earnings move in cycles spanning rather long time frames, the Shiller PE ratio, though imperfect, is a good predictor of whether to expect big, small or middling stock market returns in the next decade.

Robert Shiller Data Yale University

It’s not hard to see that investing during periods of low Shiller PE yielded better long-term returns than investing during periods of higher valuations.

Shiller also overlays interest rates and earnings. The patterns should give us pause. Return to the question I asked above: What if interest rates rise?

There’s at least two very plausible scenarios over the next 10 years that make rising or higher interest rates a strong possibility: Modern monetary theory or helicopter money – more on these soon.

What the Shiller PE really is telling people today is that the 2020s will be more like the 2000s than the 2010s.

SPY Quick Technicals

The broad measure of the stock market regularly cited is the S&P 500. Currently, the S&P 500 is a bit oversold and running into minor support levels. This could cause a slight relief rally.

Chart from TradingView

You will notice I’m using a weekly chart. Why not daily? Simply put, we are not day traders, I’m more concerned with bigger market moves over longer time horizons. The weekly charts help me get the intermediate term time frame (six months to two years) better in hand.

On the daily chart (not shown here) that most default to, the RSI is showing an oversold signal. On the weekly however, we can see that the S&P 500 has quite a bit of selling left to it before it’s truly oversold.

We also see that money flows, as measured by Chaikin Money Flow, can fall quite a bit further as well. Look to the fourth quarter of 2018 for a hint as to what might be on the horizon.

Finally, MACD, a measure of momentum, is indicating a longer-term downturn as it crosses over on the weekly time frame.

In February 2018, I covered How Low Can The Stock Market Go and about nailed it for the 2018 correction. The same story is playing out now, in my opinion. I believe the December 2018 lows are in play for later this year, possibly lower. I think there is a strong likelihood we hit that major support zone in the 220s or 230s on the S&P 500.

You’ll see that the support levels are the same today as a couple years ago. The strong support level around SPY 220 still remains fully in play. The bottom fishing price around 160 is possible, but in an era of central bank interventions and government deficit spending, I find it only possible, not probable.

QQQ As A Core Holding Instead Of SPY

The Invesco QQQ ETF (QQQ) represents the Nasdaq 100. This is a large cap index comprised of “newer economy” companies. The top holdings are:

My research shows that over 100 companies in the S&P 500 are likely to drop 50% or more in the coming decade due to deteriorating businesses. That is actually my most conservative number. I believe nearly 160 companies in the S&P 500 could be 50% lower or worse by the end of the decade.

Those at risk companies in the S&P 500 are generally “older economy” companies that are having a hard time with growth and debt management. In general, their businesses are shrinking and they will have a hard time with dividend obligations while managing debt in coming years. So, I avoid the S&P 500 index as an investment.

We will be using the Invesco QQQ index instead. These are companies tha for the most part represent the newer economy and the 4th Industrial Revolution companies in the “smart everything world.”

Here is a comparison of QQQ vs SPY since QQQ inception and the last five years. With the exception of a few very specific shot time frames, QQQ has beaten SPY very consistently.

At current, just like the S&P 500 is still showing weakness, so is QQQ. While we will want to buy QQQ eventually, we need to confirm the worst is over. Once again, the weekly chart shows continues short-term risk.

Likely this week, the QQQ will hit minor supports that trigger some people to be buyers. I felt last year those levels, which at the time served as resistance, should not have been gone above. As is often the case though, the stock market was irrational and rose higher than valuations suggest should be the case.

2020 Investing Gameplan Update

In the fourth quarter of 2019, as the stock market rallied, I started raising a lot of cash in accounts. By year-end my client’s accounts were around 50% in cash on average. Upon the Coronavirus news in late January, I started to sell more assets. By February 21st, we were on average 75% in cash (+/-) depending on portfolio risk profiles. I made the suggestion to move towards 75% cash here quite a few times.

During the week of February 24th to 28th, we made only small equity purchases of specific securities. We did not buy any large positions at all. The largest position we added to was the Van Eck Gold Miners ETF (GDX) on Friday morning at the open when there was an initial sell-off rumored to be due to people selling assets that were up in recent quarters to meet margin calls. Client accounts are 8-10% GDX now.

My thesis on gold is outlined in this article published in January on Seeking Alpha:

Massive 2020s Gold And Gold Stock Bull Market Is Just Beginning

You will receive an ETF Buyers Guide tomorrow. In it are 8 exchange traded funds to use to build your asset allocation. A few are core holdings to build around, several are for trading cyclically (6-months to 2-years). 

Disclosure: I am/we are long GDX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own a Registered Investment Advisor, Bluemound Asset Management, LLC, but publish separately from that entity for self-directed investors. Any information, opinions, research or thoughts presented are not specific advice as I do not have full knowledge of your circumstances. All investors ought to take special care to consider risk, as all investments carry the potential for loss. Consulting an investment advisor might be in your best interest before proceeding on any trade or investment.