The stock market has been crushed in recent weeks and is officially in Bear Market territory (down more than 20%). Market pundits suggest that since markets usually provide information in advance, that a recession is “possible.” As I’ve indicated in a seekingalpha.com article earlier, I believe we are in a recession already, and the Fed’s surprise 50 basis points cut, followed by another 100 b.p. on Sunday would imply they fear this is the case as well. Revisions to company earnings are going to be scathing. Analysts tend to overshoot when optimistic and, initially, are reluctant to revise downward when things look grim – but revise downward they will in time, and with gusto.
If we expect 10% lower corporate earnings for this year (and estimates may be even worse when capitulation truly sets in), then the downside risk to the S&P 500 is closer to 2,250 – the long-term average P/E times roughly $150 earnings for the index. This would imply a decline of about 35% from the market high. The seizure of the U.S. and global economies sparked by the coronavirus (layoffs, reduced demand for travel, oversupply of crude oil, supply chain disruptions, and the cancellation of sports and conferences etc.) is also having a profound effect on credit markets. One risky asset, as far as the financial services sector is concerned, is corporate debt. The same events unfolded during previous crises. Markets responded – stock prices tumbled, and sovereign bond prices rose as investors (institutional and retail) in general seek to take risk of the table.
The recession (we’re undoubtedly in it already) then is not the worst of our woes. It’s the impact of a drastic economic slowdown on financial markets that creates the most havoc. It’s unlikely the Fed would have taken such drastic measures because of the coronavirus or even the prospect of recession. I’ve mentioned in previous articles that corporate debt was viewed by the US Federal Reserve as a key vulnerability in the economy.