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Academics say that stock markets are a “discounting mechanism.” That is, investors discount, or assess all available information when pricing securities. What makes it interesting is that this process is subjective – different investors place more emphasis or confidence in some data points than other investors. In this regard, investors are constantly making subjective risk-reward assessments. The result is a continual tug of war within the stock market. On most days, this tension goes unnoticed. However, when ambiguity increases, the tension becomes more apparent.

COVID-19 started spreading in China in December 2019 when a cluster of cases were identified in the city of Wuhan. The first US case was reported on January 30 in Washington state, but US investors didn’t seem to notice, and the S&P 500 Index went on to hit its all-time high of 3,386 on February 19. However, the market was now on edge as further coronavirus news came out. Two days later, 20 new US cases were reported and the market reacted by falling 1.4%. Since then, new infections in the US and elsewhere have continued to rise even as containment efforts ramped up resulting in an economic shock. This is driving a stratospheric rise in uncertainty:

With the global economy stuck in a heightened state of ambiguity, it becomes difficult to price assets. That leaves the market vulnerable. With the market bereft of reliable information needed to assess risk, where do investors turn? To the daily news cycle! With each passing day, news of containment efforts (cancelled sporting events, closure of theme parks, schools) has Wall Street analysts guessing at the impact this has on corporate earnings. Add in a market share war between Saudi Arabia and Russia that’s resulted in a 33% decline in crude oil prices and economic ambiguity has risen to gargantuan levels. The result? Massive daily stock market losses with the severity dependent upon that morning’s headline.

This being the case, and with all eyes watching the daily coronavirus numbers, we add one unfortunate observation: the number of patients diagnosed with COVID-19 is probably going to rise. We don’t claim any expertise in the matter, but from our observation coronavirus contagion appears to follow a pattern: a slow rise followed by a sharp increase in the number of new infections. In Italy, new cases in late February amounted to only 100-200 per day.  That surged to over 1,000 per day in early March and over 2,000 per day as of March 12. This suggests that worse news may be ahead – and this will not be welcomed by financial markets.

The current coronavirus outbreak has many making comparisons to the 2003 SARS epidemic. SARS also originated in China, and then spread to Hong Kong by a doctor who unknowingly became infected after treating SARS patients in southern China. Once it got hold, it quickly spread, infecting 1,755 and causing 299 deaths in Hong Kong between February and July 2003. Thankfully, local officials acted quickly and were able to limit the transmission of the virus even as it crippled their economy. After the initial sell-off, Hong Kong stocks staged a sharp rally in April 2003 despite new SARS infections being reported.

By June, life in Hong Kong was returning to normal. The below left picture is of the Stanley, Hong Kong waterfront on February 9, 2003 at the start of the SARS outbreak. The picture on the right is Stanley, Hong Kong just four months later (June 4, 2003). Source: 1970s-2000s Atkins Photo Album

We recognize there’s a big difference between the SARS and COVID-19 outbreaks. The SARS outbreak largely impacted the Hong Kong and other local economies while the current COVID-19 outbreak is wreaking havoc on the global economy. This is evident in the difference between the performance of the Hong Kong stock market at the time and US markets during this current downturn. We mapped the performance of the two markets from the start of both viral outbreaks. The current market adjustment has been far deeper and more violent than that experienced in Hong Kong during the SARS crisis.

Adjustments are also being felt in fixed income markets. US Treasury yields have fallen to historic lows and credit spreads are widening. However, this is not the same environment we saw during the dot.com bust or the global financial crisis. Those were instances where market excesses resulted in severe mispricing of an immense amount of financial assets, which is not our current situation. Indeed, market stress indicators remain much more muted in fixed income markets than we see in equity markets. While investors may be pricing in a hit to corporate profits, they are not yet pricing in significant business defaults (chart below).