Too many investors are failing to grasp that the coronavirus recession may be longer and tougher

Prices for stocks, bonds, commodities and other assets have become disconnected from fundamentals. They will need to fall much further if the coronavirus crisis continues for longer than expected, resulting in a deep downturn and a slow recovery.

Markets largely assume that the crisis will be…

short-lived, a rapid economic recovery will ensue, and policy makers are in control. In truth, the public health crisis from COVID-19 may continue in some form, and for some time. A vaccine is not imminent and may never be found. Even if a vaccine is produced, global vaccination takes time. Even with a vaccine, the virus may mutate, as with influenza or the common cold, starting the cycle again.

Moreover, if one country contains the virus, there will be hotspots and without rapid 100% testing, the ability to move freely, especially internationally, risks new infection waves. The probable scenario is some relaxation of national lockdowns but continuance of travel restrictions and limits on certain activities. Periodic re-introductions of strict controls if there are new outbreaks cannot be discounted.

Ignoring this possibility, current forecasts assume economic activity is restored quickly. Forecast earnings and dividends fall by 25%-50% in 2020 but then return to normal. Valuation models assume a short-term interruption in earnings and cash flows, insignificant over a 10-year investment horizon.

But if the lockdowns persist, then large sectors of the global economy face negligible revenue, losses, no dividends and insolvencies. Significant rises in bad debts are not incorporated in valuations. Without cash flow, risky assets, such as stocks, residential and commercial real estate, and infrastructure, will be worth much less. Investors have failed to grasp that most businesses right now are in survival mode.

Weaknesses in the economic structure mean that any recovery may be tepid at best. Economic activity may stabilize at levels substantially below normal levels. Lower growth, falling incomes and demand, as well as excess capacity, may place deflationary pressure on prices of certain products. Forecasts and asset values do not countenance this possibility.

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