To understand why there was a huge decline in the stock market on Monday, you have to understand what happened last week.
News that the coronavirus was spreading was hardly a secret a week ago. Cases were spreading throughout China and other parts of the Far East. Italy had a problem. Cruise ships saw the disease spreading. Even whole towns in China were being quarantined.
And the World Health Organization was issuing regular warnings.
Yet last week stock prices in the US managed to rise uninterrupted.
How’d that happen? What was Wall Street thinking?
There’s always some denial among professional traders when something bad is happening. “Don’t let individual investors see you sweat,” seems to be their motto.
But there was something else going on last week. It was one of those options expiration periods. And professional traders not only didn’t want to show sweat, they also wanted their contracts to go out in the money.
So they needed to squeeze stock prices up.
And on Monday the pros didn’t need to keep up the facade that everything was still great. Oh yeah, they seemed to say in unison, the virus is a problem.
So, without professional traders propping them up, all the stock market indices fell more than 3 percent on Monday for their worse session since October 2018.
As I mentioned in my column a week ago, stock prices are very high when compared to their normal historic levels. At the time, the price-to-earnings ratio of the Standard & Poor’s 500 index was at 19.2.
Compare that with the historic average price-to-earnings ratio of only 14.8. To make it simple, stock prices would need to fall 23 percent to get back down to that average.
The 3 percent-plus decline on Monday may have put fear in the hearts of investors. But it still doesn’t put stock prices anywhere near the historic 14.8 price-to-earnings ratio.
There is, of course, another way the PE’s could get back to more normal levels. Corporate profits could rise.
But here’s the problem. Even before the coronavirus struck, the US economy was only growing at an annual level of 2 percent to 2.5 percent. So it wasn’t like corporate profits were getting ready to soar.
Soaring is much less likely now that the virus is catching so much of the world’s attention and causing the shutdown of businesses in China that supply US companies with products.
There’s also the reverse problem: with China concentrating so much on containing the virus, it’s very unlikely that its citizens will be out and about buying McDonald’s burgers, Nike shoes and Apple iPhones. So reduced exports of US goods to other parts of the world will also hurt American companies’ profits.
I asked David Aurelio, senior manager of Refinitiv, to find out for me how much the virus has already trimmed corporate profit expectations. Here’s the answer.
On Jan. 31, US corporations expected their profits to be up 5.4 percent in the first quarter of 2020. Now, those same companies are expecting only 3 percent higher profits.
Companies are always too optimistic at the start of the year.
That 2.4-percentage-point drop in earnings expectations is already what could be expected for the entire quarter. But there is still more than a month left in the first quarter and coronavirus fears could get worse.
There are two stock market saviors (other than wily professional traders) that Wall Street always counts on. The first, of course, is the Federal Reserve. A drop in interest rates is almost always the tonic that the stock market needs. It pushes investors out of fixed rate investments and into riskier stocks.
And while Fed rates are already low, they could go lower.
The problem this time is that the economy is not being hurt because companies can’t borrow money at reasonable rates. Rather, it’s that companies won’t borrow if they don’t know when their business will return to normal.
The other savior is something called the President’s Working Group on Financial Markets, which is also known as the Plunge Protection Team. This group has always been almost mythical, and anyone who talked about it was thought to believe in conspiracies.
But lately it has come out of the shadows. And almost everyone now believes this group tries to protect the stock market in dire times like during the Great Recession.
But a 3 percent drop like Monday’s isn’t dire.
A 20-percent drop in stock prices — while that’s a normal correction — might get the Plunge Protectors’ attention. Even then, the action would be subtle. Washington would try to rally Wall Street firms to buy stocks, perhaps giving them a guarantee that they won’t lose money while acting in the public’s interest.
But there’s trouble if this happens as well.
Saving the stock market from disaster — while it would be applauded by most Americans — might be seen as a political move to protect Donald Trump’s reelection chances. So this would not come without criticism.
There’s one more thing that could be impacting the stock market that I should bring up.
With Bernie Sanders galloping to a win in the Nevada caucus on Saturday, some people have suggested that Wall Street on Monday was worried that the self-proclaimed socialist might become president and upend capitalism.
Long ago I predicted that Sanders would end up being the Democrats’ presidential candidate in 2020. Others now see that as an inevitable occurrence.
But I also said Sanders was going to lose to Trump.
I still think that. And I believe most people on Wall Street agree that Sanders can’t and won’t win.
So the notion that Sanders’ strength in the Democratic primary caused Wall Street’s grief on Monday seems misplaced. Health care stocks certainly did have a particularly awful day Monday because of Sanders’ plans for health care
But all in all, Sanders’ strength on Saturday in Nevada may have been the one thing that Wall Street thought was positive as this week started. If Sanders is the Democrats’ nominee, President Trump will almost certainly get reelected, and Wall Street likes that.
Source: Read Full Article