As you are probably aware, over the last week the U.S. equity markets have sold off, losing over 10% from their recent highs. This is being driven by concerns that the Coronavirus (COVID-19) will continue to spread, negatively impacting global commerce and the potential for accelerated economic growth. Many companies are modifying or even scrapping their previous financial guidance, which is serving to underscore the uncertainty of the outlook.

That said, we at Atlas have been watching credit spreads, which can serve as the “canary in the coal mine” for future equity market activity. This is based on the belief that the bond market, which is much larger in total asset size than global equity markets and more focused on a longer-term horizon, is a more reliable source of information and guidance. Simply put, credit spreads are basically the extra interest that a bond investor would demand for taking on credit risk rather than opting for a presumed “risk-free” investment, such as a U.S. Treasury instrument. This credit spread is driven by very similar factors as those that influence stock prices. So, when credit spreads get larger (or “widen”), it can indicate that investors are demanding more compensation for the credit risk they’re acquiring. When credit spreads become smaller (or “tighten”) it indicates that investors are less concerned with credit conditions.

Credit spreads are not appearing to widen drastically in this equity market selloff. As of this writing, the Bank of America High Yield B Option-Adjusted Spread is at 4.34%, up only 0.32% from the beginning of February. [1]  For context, over the last 20 years spread levels have ranged from a low of 2.36% to a high of 20.84%, with an average of 5.66%. As recently as August of last year it stood at over 4.90%.

It is also important to understand that we’re in a lower rate environment than we have been at any point in those 20 years, so spreads would be naturally tighter. But notwithstanding that, the direction and velocity of change is the important factor to watch. While spreads are widening, they don’t appear to have widened as quickly as stock prices have fallen over the last week.

So, the point here is that we believe the credit markets, in their collective wisdom, seem to be less alarmed at the situation than does the equity side.  In my experience, the credit markets are typically more prophetic.

We at Atlas view this event like an unexpected market correction, not the beginning of another event like the financial crisis. “Corrections” by definition are market events involving negative volatility of 10% or more. According to CNBC, corrections average about 13% and last about 4 months. The last of these occurred in December of 2018.[2]

The question on our minds and that of most investors is… “what is the magnitude of the negative impact of the Coronavirus on the economies of the world, and thus the impact on corporate profits?” At this point, we think the stock market reaction is somewhat overdone. While it may take weeks or months for the effects of this issue to work themselves out, we think that the outlook at the 18-month horizon will be curtailed, but only moderately.

One last point worth mentioning here is that this reaction may be exacerbated by the flows of funds out of passive (or indexed) investments. Passive investors’ main signal is price action, and with the recent decline, many individual passive investors are running for the hills. We think that this is providing an opportunity for insightful active managers to find relative bargains in the stock market, to the extent that they have cash available for purchase. Key in this is staying composed, and evaluating opportunities selectively.

As always, we recommend that investors view this event in the context of how market corrections have occurred over time, and how they have resolved. Attempting to time out and then back into markets at opportune moments, has never been a practical investment strategy. In contrast, even in the most extreme market events, maintaining composure and one’s asset allocation through the event has been a reliable means of defending long-term return potential.

If you have questions about this or any other financial matter, please feel free to contact your Atlas Wealth Management Advisor.

John C. Ogle
Chief Investment Officer

[1] https://fred.stlouisfed.org/series/BAMLH0A2HYB. Data reported as of 02/26/2020.
[2] https://smartasset.com/investing/market-correction-definition-duration-and-everything-else-you-need-to-know