Financial markets should be able to recover from the recent sell-off with the help of the Federal Reserve and the U.S. government, according to JPMorgan Chase.
The firm believes stocks have priced in a worst-case scenario that has not yet come to fruition. With fiscal and momentary stimulus, the risk/reward is "improving."
"The market has gone ahead and priced in too severe of an adverse scenario, assuming we get timely and strong counter-policy response and a COVID-19 outbreak that peaks in the coming weeks," JPMorgan's chief U.S. equity strategist Dubravko Lakos-Bujas said in a note to clients Tuesday.
The coronavirus outbreak has roiled markets in recent weeks, forcing investors to blindly gauge the impact of consumer demand and supply chain disruption. Adding to the chaos, an oil price war broke out over the weekend, causing the commodity to crater nearly 25%. All three major averages are more than 16% off their most recent highs, flirting with bear market territory.
The Dow Jones Industrial Average plunged more than 2,000 points on Monday, its worst day since the financial crisis. The S&P 500 dropped 7.6% and the Nasdaq Composite fell about 7.3%.
JPMorgan said a market sell-off of this magnitude typically implies a 65% to 75% chance of recession in the next 12 months, based on history.
"The speed and intensity of the sell-off has shaken investor confidence with many now modeling recession scenarios even though there is still significant lack of clarity on the actual fundamental impact," Lakos-Bujas said.
The Fed is widely expected to lower interest rates next week at the Federal Open Market Committee meeting, in addition to its emergency rate cut last week. JPMorgan thinks the FOMC may cut to zero, though the market is anticipating something less dramatic, with the most likely scenario now a 75 basis point cut. Plus, the Trump administration is floating the idea of "a payroll tax cut or relief" to offset the negative impact from the coronavirus, sending stocks up on Tuesday morning.
"Policy supports should ultimately outlast the outbreak," Lakos-Bujas added.
JPMorgan reiterated its year end S&P 500 price target of 3,400.
The firm also noted that although the coronavirus market rout has wipe out two years' worth of gains for the S&P 500, if history is any gauge, "equal or worse single-day sell-offs were followed by median forward returns of +4% and +17% over the subsequent 1-week and 12-month periods, respectively."
Futures on the Dow Jones Industrial Average indicated an opening surge of nearly 1,000 points on Tuesday. S&P 500 futures and Nasdaq-100 futures also pointed to a sharply higher open for the two indexes. Oil futures also pointed to gains.
"It is important to keep in mind that the sharp sell-off is also symptomatic of a fragile market structure that can amplify price both downside and upside — a volatility shock coinciding with a collapse in liquidity and significant forced selling by systematic portfolios," Lakos-Bujas wrote.
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— with reporting from CNBC's Michael Bloom.