As the market heads well into correction territory, the one thing that has struck me is people are trading it as they would a typical recession. This is absolutely the wrong construct. The impact from recessions persist. Corona is like a hurricane – it is a one time hit that will hurt for a quarter and then disappear.
This will be a relatively short note mainly because the point is very simple, but I think it’s been lost by the market.
How To Price In A Recession
Because a recession is of unknown duration, the market tends to capitalize the lost earnings. In other words, if next year’s earnings are going down 10%, the stock will go down 10%. Note, this isn’t always true, particularly for cyclicals (if earnings go down 50%, the stock won’t go down one for one). But the driver of the stock price will be the impact of the recession on next year’s earnings.
How To Price In A Hurricane
While at times markets will overreact to the potential damage of a hurricane, for the most part a stock’s market cap goes down by the $ amount of damage it will incur from the storm. At times when the ultimate path is uncertain, losses may skew towards the worst case, but by the time landfall approaches, the stock is down by the book value hit.
The one exception to this would be if the amount of losses are enough to trigger a capital raise. In that case, the stock also goes down by the potential dilution.
But typically, stocks go down by their multiple of book value rather than a multiple of the earnings lost. This is rational as there is no impact on forward earnings (ignoring for now any possible improvement in pricing).
Why Corona Is A Hurricane
While there is the potential for corona to cause a short term recession, it would only be for one quarter. It should not impact 2021 EPS as the disruption to activity is a one-time event (unless you believe it won’t die out in a couple months with warmer weather).
While the severity of the one-time event may be unknowable, this isn’t any different from a hurricane a few days away from Florida that may hit anywhere from Miami to going south of Florida and into the Gulf. Yes, the worst case (Miami or Spanish Flu 2) could happen but it’s not the most likely. More likely is it will do the equivalent of hitting the Keys.
The one main difference is the uncertainty of a hurricane resolves itself in days. The outcome of corona is likely going to take weeks. While that may create some angst, it doesn’t change the ultimate conclusion: stocks should be marked down by their potential one-time earnings loss and no more.
I’ll have more to say next week on some specific dislocations created by the selloff.