Concerns Over Coronavirus Trigger Correction

Quickest correction on record

Since February 21, the S&P 500 has corrected over 12%. This pullback is the quickest correction on record. The market peaked on February 19 and experienced significant selling pressure last week. Year-to-date, the S&P 500 is down 8%, while the JSO Equity Model Portfolio declined 4%. We attribute the difference in performance to our conservative strategy and preparedness for a correction coming into the new year.

In October of last year, we communicated our decision to reduce equity exposure in the JSO model by 20% due to what we viewed as overly optimistic earnings estimates and elevated valuations. In addition, the equity funds in our portfolio were defensively positioned with excess allocation to cash. We are pleased to report that this strategy has proven advantageous in the context of the market’s current pullback. The following chart depicts the comparative rates of decline between our equity model and its benchmarks. From February 20-28, the JSO Model declined by 7.9% while our benchmark fell 11.4% and the S&P 500 dropped by 12.7%.

JSO Equity Model - 2/20/2020 to 2/28/2020

JSO Views

Uncertainty bodes ill for the stock market

The market does not like uncertainty, and events like the coronavirus outbreak tend to trigger selling pressure. The investment community is grappling with the loss of human life and the impact to businesses and the global economy.

Apple announces revenue will fall short of expectations

On February 17, Apple announced that the coronavirus outbreak would adversely impact revenue. It was one of the first companies to pre-announce. Others have followed, including Microsoft, and we expect more companies to make similar announcements in the coming weeks.

Earnings estimates are being cut

Our readers know that we have had concerns that earnings estimates for the S&P 500 companies looked optimistic even before the coronavirus impact. At the beginning of the year, the consensus estimate was +9% growth for 2020. Some investment banks like Goldman Sachs now expect no growth for this year. While it is unclear how long the coronavirus will persist, investment banks have already begun to reduce earnings estimates. According to FactSet, first quarter profit estimates have been cut by 3.3%. We think there is potential for further reductions, particularly for global companies.  

Valuation analysis

Valuations remain elevated even after this pullback

While the S&P 500 has corrected, valuations remain elevated, trading at 19% above the 10-year average of 14.8x. Thus, we do not believe that the market is oversold.

Opportunity or the beginning of a longer-term trend

We expect a relief rally in the near-term after 7 days of selling. While tempting to increase equity exposure, we are wary of rushing in because the market valuation remains high and the earnings outlook is even more uncertain in the wake of the virus. We are weighing whether the correction presents an opportunity to buy. What tempers our enthusiasm is that the S&P 500 is trading at 17.5x forward earnings estimates which is still more than one standard deviation from the mean.

S&P500 Price to Earnings Ratio, 2010 – Feb 28, 2020

Outlook

Episodic, unlikely structural

The recent correction does not change our long-term bullish view of the equity market. We believe this pullback is attributable to what is likely to be a one-off event. What makes us tentative about buying into this weakness is the uncertain duration of the impact and the fact that valuations remain elevated. Indeed, the market typically trades sideways during periods of uncertainty. We opt to continue monitoring market activity before adjusting our equity exposure in the model. Until we have further conviction on the direction of either earning expectations or valuations, we are inclined to maintain our relatively conservative position.

If you would like to learn more about the JSO Equity Model, please do not hesitate to contact us.

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