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Putting the Correction in Context

The sell-off in stocks likely sparked by the coronavirus outbreak also reflects a broader set of risks that have been apparent for the past six months.

It may seem hard to believe now, but the S&P 500 hit a record high more than a month after news of the coronavirus outbreak in China was first reported. On that day—Feb 19, 2020—the index stood nearly 40% higher than its recent low in December 2018.

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After a 14-month run like that, investors should have been bracing for a correction, even if the outbreak had remained contained. Nearly every other rolling 12-month period in history has included at least one market correction, defined as a decline of at least 10% from its top, and we had yet to see one.

Now, investor concern that the virus will disrupt supply chains, impair consumer confidence and lead to economic recession has triggered a 13% drop in the S&P 500 in just seven trading sessions. It’s one of the fastest sell-offs in history. While the spread of coronavirus globally was likely the catalyst, the correction also makes sense in context of the broader set of risks I’ve been highlighting in recent months. These are the main ones, all of which have receded somewhat:

  • Historically high valuations: The price-earnings ratio of the S&P 500 had climbed above 19, within the top 10% of the past 100 years. Now it’s a more reasonable 17.
  • Nonexistent earnings growth: S&P 500 profit growth was flat in 2019, and Wall Street consensus estimates projected about 10% growth this year, which seemed unrealistic. Now, stock prices seem to be aligning with what may be more realistic corporate profit potential.
  • Growing signs of investor exuberance: Extra liquidity from the Federal Reserve had been fueling gains, while measures of investor sentiment and positioning suggested that investors were buying stocks partly based on the fear of missing out. Now, investors are less complacent, which means markets aren’t as fragile. That’s a better foundation for potential future gains.

I don’t want to seem cavalier. Sell-offs this fast and deep can be unsettling. They may signal a paradigm shift that would require investors to adjust their investing strategies.

For now, however, I recommend that investors remain patient. Further downside is still possible, but on the other side of this coronavirus outbreak, demand should rebound, fueling a V-shaped economic recovery. Investors should keep close watch on the evolution of this health crisis and its impact on consumer confidence. Barring a full-blown recession that would likely result in a bear market, it is likely that six, nine or 12 months from now, global stock markets will be higher.