There has been some justifiable concern about the disease outbreak in Wuhan, China, and fear of the coronavirus has hit the markets this week.

The virus has spread beyond China’s borders, with some countries restricting travel from China. In fact, Hong Kong closed its border with China on Tuesday.

The human cost of a viral outbreak like this one is tragic, and hopefully, the disease will be remedied before more lives are lost. However, this is once again a moment when “externalities” seem to be having an impact on the financial markets rather than core fundamentals.

The question we have received more than any other with respect to the outbreak’s impact on the financial markets is how far will prices fall in the short term?

Although this is a reasonable question, the answer is tricky. There were plenty of headlines blaming the virus for Monday’s declines. But that connection could easily be just an unlucky correlation.

Normally, in a situation like this, we would look at historical examples and see if we can find common patterns to develop a probability estimate for how the outbreak is likely to affect stock prices.

Although the data is always messy when you try to find patterns kicked off by calamities, this is exactly what we do when hurricane season hits the U.S. South Atlantic. However, in the case of disease outbreaks, the data is beyond messy. It’s very difficult to interpret.

Although there are many outbreaks each year, the worst of these in terms of human costs appear in developing or frontier economies (sub-Saharan Africa, Pacific Island nations). These are economies that have little financial spillover effect on the markets.

The Impact of Disease Outbreaks

Because the relationship between disease outbreaks and stock prices is so cloudy, we would treat this as an issue driven by headlines rather than actual economic activity.

For example, the Ebola outbreak of 2014 affected transportation stock prices like Delta Air Lines (NYSE:DAL) and United Airlines (NASDAQ:UAL). As you can see in the following chart, UAL dropped as much as 12% only to rally 89% by January 2015.

There are still Ebola deaths in the world. There were 198 deaths from an outbreak in the Democratic Republic of Congo in 2018 alone, but that didn’t seem to affect markets.

This sequence of an outbreak, followed by breathless headlines and completed with a market whipsaw is common. However, it all relies on the behavior of the press more than any intrinsic feature of the outbreak itself.

Usually, the most dramatic impact disease outbreaks have on stocks is focused on an individual sector or group of stocks. For example, healthcare companies often get a short-lived bump when press coverage of the outbreak spikes. Transportation stocks often suffer.

During the swine flu outbreak in 2009, the number of headlines spiked through the summer and late fall. DAL had a flip flop like UAL’s in 2014. UAL lost 30% during the crisis and gained 130% by April of 2010.

Johnson & Johnson’s Outbreak Rally

Companies in healthcare did fairly well while the headlines were still on the front page. Johnson & Johnson (NYSE:JNJ) rallied 15% on fears of vaccine and hand sanitizer shortages, but it dropped 35% after the fear began to subside, which you can see in the following chart.

So, what should investors take away from a study of disease outbreaks and the market? Although we had to use some subjective judgement, our study of outbreaks that met a minimum level of headline coverage revealed a weak but similar pattern to the one we see during hurricanes.

Just as oil companies rally prior to hurricane landfall, stocks expected to benefit from the outbreak — healthcare being a good example — rally briefly for an average of 7% gains. As the news fades, they give up their gains and drop below their initial levels. They typically fall an average of 10%.

Similar to how refineries drop prior to a storm and then rally following landfall, transportation and shipping stocks tend to suffer the most during the initial press coverage of an outbreak. They fall an average of 18%, but then they rally an average of 62%.

We should note that the size of some gains in transportation could partially be due to bull market distortion. We don’t think the forward average is likely to be that high.

The total whipsaw cycle tends to be brief — one to three months — and barring something unexpected, we would expect that to be the case this time as well.

We don’t expect the current outbreak to have a long-lasting negative impact on the market. We are much more concerned about falling profit margins and a reluctantly dovish Federal Reserve than a disease outbreak.

The Bottom Line

Besides the Federal Open Market Committee’s announcement yesterday, this is a slow week for economic reports. This makes today a good opportunity to address the coronavirus outbreak in China.

At this point, we don’t expect the outbreak to have a significant impact on prices.

However, although earnings are currently trending above expectations, profit margins continue to be squeezed, which is concerning. Earnings growth is negative on a year-over-year basis for the fourth quarter, so a cautiously bullish outlook is still warranted.

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