Is the Coronavirus Crash Rooted in Market Bias?

Julian Koski, Co-Founder and Chief Investment Officer, New Age Alpha
Mar 3, 2020 1:15:47 PM 4 min read

Market collapses such as the one during the last week of February are rare. It takes a huge catalyst to cause a market-wide, and in this case, worldwide, selloff of the magnitude we have just seen. Coronavirus appears to be such a catalyst. Why? In addition to the obvious human cost the virus could have, the cost of disruption to global trade will be enormous. This is the risk the market is now pricing, but only time will tell whether the selloff is an overreaction. 

As tragic as the news is for humanity, inevitably investors will be looking for opportunity in a market that is now 15% cheaper than it was as recently as mid-February. But as the old adage suggests, don’t try to catch a falling knife. It is imperative that investors carefully consider how attractive stock price was before the selloff and how a company’s performance will be affected by the coronavirus. 

 

Clear vs. vague information 

There are two types of information that affect stock prices: the clear and the vague. Clear information like an earnings release is generally impounded into a stock price appropriately because it is interpreted by investors in the same wayHowever, it is the vague information that can cause mispricing because investors and their biases are left to guess exactly how the value of the stock has changed. 

Whether it relates to the severity of the illness or the impact on the economy, information on the coronavirus is entirely vagueWe know it is bad, but we don’t know how bad. That makes it difficult to price it into stocks, allowing fear to run rampant and possibly push stock prices far too low. This impact of the coronavirus on stock prices is an example of the H-Factor. The H-Factor identifies the impact of vague information on stock price by balancing what is not vague – things like fundamentals – against price. This reveals the risk an investor faces as the result of a company being priced by potentially biased market. A company with a high H-Factor could be heavily impacted by the analysis of greedy and biased humans that have pushed the price too high. But a low H-Factor is often the result of fearful investors that have pushed the price too low.

It is also important to avoid companies that do not have a sufficient cushion to protect against a decline in performance. Companies with low H-Factor scores have a history of performance that suggests they can easily deliver the performance to support the current stock price. That is to say, the stock price is low enough that, even if performance is negatively impacted by the coronavirus, the company should still be able to perform at a level consistent with what its stock price requires. These are the companies investors should be looking at to buy in the current stock market environment. 

Drawing conclusions without fundamentals

In 2015, Chipotle Mexican Grill faced a crisis of its own when 55 people fell ill as the result of a strain of E. coli that originated in Chipotle restaurants, frightening customers and investors alike. Over the next two years the stock would lose more than half its value despite sales staying, all things considered, quite strong. By October of 2017, as the stock was bottoming, sales had already nearly rebounded all the way to their pre-crisis highs. Clearly investor pessimism and not fundamentals were driving the pricing of Chipotle stock. This is the H-Factor at work.

When they read the news today, most investors immediately recognize that although the broad economy can only be hurt by the spread of coronaviruscertain companies will benefit. This can lead many investors to draw conclusions that may not be based on a full set of information. For example, 3M Company includes within its diverse product line respirators and surgical masks. Consequently, 3M’s stock has largely avoided the selloff as investors speculated it could be a coronavirus hedge. It is hard to know exactly the extent to which such products could help the company, but the company’s “Safety and Graphics” segment, under which respirators and masks fall, contributes less than a quarter of the company’s operating income. Thus it might seem too optimistic to think 3M can escape the impacts of the virus entirely. 

Furthermore, 3M currently has a price that puts its implied revenue growth very high relative to its historical ability to deliver growth. Keep in mind that if the company is indeed negatively impacted by the virus eventually it’s historical growth will be lower and it will be even less likely to deliver the performance to support its stock price. We might interpret this to mean that investors relatively optimistic about 3M have kept the price too high by interpreting vague information on the coronavirus. 

It is always hard to know what to do in market crises, but having a disciplined and objective way of analyzing choices is very helpful. The H-Factor provides both the insight and the methodology to mitigate the risk of chaotic markets. 

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Julian
Kern
Co-Written by Julian Koski, Co-Founder and Chief Investment Officer and Andy Kern, Senior Portfolio Manager