Staying Grounded During Epidemics

I have been traveling over the last couple of weeks, during a period most would characterize as a time that one should not, and would not, travel on an airplane. On my flight back from Park City, Utah on Friday, both of my flights were completely full, and outside of people wiping down seats with disinfectant wipes, it was very much business as usual. I mention this because if you were to stay home and only follow the news, perception can deviate quite significantly from reality.

I am going to lay out some quick-hit bullet points for those that do not want to read this letter in entirety:

What happened

• Market sentiment was bullish coming into the year; optimism was very high after a great 2019 and an even better start to 2020
• This means that markets were “priced for perfection” – meaning that the market assumed that the positive news would continue
  • When this happens, the market can be especially vulnerable to rapid price corrections, or sharp downturns, when the news turns less favorable
• Presidential election years have in the past also increased potential for volatility, with some investors on edge
• The Coronavirus (COVID-19) has been in the public domain for the past month-plus, however investors initially underreacted to news of the virus thinking it would be contained to China.  Over the past couple of weeks, news worsened and optimism turned to pessimism very quickly.

The Bad            

• Investors are not overreacting considering the risks of the worst-case scenario
  • While there is still a multitude of possibilities with the virus, in times of fear or panic human nature tends to focus on the worst-case scenarios
• S&P 500 is down more than 19% since February 21st, which is one of the most rapid declines in the last 90 years of the market
• Prices are now being driven by fear of being the last one out of the market
• There is still a lot of uncertainty as to the full impact of the virus – which investors dislike tremendously

The Good

• Once there is certainty, even if negative, it should start to have a positive impact on the markets
• The number of active cases appears to have peaked at the end of February and the fatality rate may have been overstated based on what happened in China.
• The Federal Reserve cut rates by 50 bps last week in an emergency measure, which can happen outside of their regularly scheduled meetings
  • This could be included in both the good and the bad section, since the market’s reacted very negatively to this move by the Fed.
  • We think any time the word “emergency” is paired with an action by any financial authority, it opens the possibility of negative interpretation and can create more of a panic
  • However, intermediate term, the dividend yield on the market and potential total-returns for the stock market in general look very attractive relative to bonds. (TINA- There Is No Alternative)
• As of right now we still have a positive and healthy economy with low unemployment, improving wages and low inflation
• Even though the market is down significantly this year, the market is still positive on a year over year basis
• Many analysts were worried about the stock market becoming overvalued, this does not appear to be the case any longer and soon we may start to see some great buying opportunities
• Looking at past epidemics since the 1980s, markets more than fully recovered within 6 months

Coronavirus

What is more contagious?  Fear or the Coronavirus?

I would argue that based on the widespread usage of social media in the current environment, fear is much more contagious and harmful to investors’ net worth. The network effect is mostly used in the context for the value of a product or service increasing according to the number of others using it. However, I think that it also influences the weight people place on news based on the number of people following a specific outlet or article. This is especially strong during times of panic, derived from the inherent comfort in numbers. However, the herd mentality is recognized as a harmful bias in investing, and we would argue it is much harder to resist in our era of social media dominated interactions.

With that in mind, I am going to attempt to give a balanced view into what is going on, followed by our take using several trusted sources our team tracks.

Active Cases vs. Total Cases (source: https://macro-ops.com/coronavirus-cheat-sheet/)

The media mostly focuses on the total cases number, while active cases excludes those who have died or have recovered and is arguably more accurate as a measure of progress in containing the disease.

This shows that active cases peaked a few weeks ago on February 17^th and has been trending lower. We will keep monitoring the trend and would not be surprised if it peaks again.

Fatality Rate (source: https://macro-ops.com/coronavirus-cheat-sheet/ and NYT)

Estimates are all over the map, and the media outlets like to focus on the number from China, and experts are arguing that this number is overstated. A more balanced view on the potential fatality rate (the number of infected that die from a disease) can be seen in the chart below, which depicts a much different story.

 

Epidemics and Stock Market Performance (source: First Trust Portfolios, L.P.)

One of the best charts for historical context was published by First Trust, and it has all epidemics globally since 1980 plotted on a chart of the S&P 500 performance. It also shows what the stock market did the following 6 and 12-months performance wise.

Again, this time could always be different, but one of the variables/factors that has changed the most from those time periods to today, is the ease of access to news and information. This time around, there is much more awareness around the progress of the virus, which is updated in real-time, through a dashboard published by John Hopkins. Can you imagine if everyone tracked the seasonal flu in the same manner?

This is a double-edged sword, and in theory, it should also help spread the news of containment in a much quicker fashion than what we have experienced historically. However, this assumes that the spread of information is based on reality not sensationalism.

Overvaluation and Irrational Exuberance

The good news is that prior to the recent correction, many investors pointed to overvaluation and strong recent performance as a reason for staying on the sidelines. Corrections can be healthy for the market and are often necessary to bring stock prices back down to reality. Based on history, performance coming out of this drawdown should be exceptionally strong and will be much stronger if cash that was previously on the sidelines comes back in the market this time around. Just as the market can experience “irrational exuberance” and push stock prices into bubble territory, the market can also display irrational fear and panic (swinging from greed to fear). Corrections have the potential to bring over-heated markets back to reasonable valuations, but they can also overshoot reality.

Trend-Following and Risk-Management

As noted earlier, the herd mentality/effect is not limited to interpretation of news and social media posts. It is also present in the strategies investors adopt to manage risk and time the market. In today’s environment, it is easier than ever to write algorithms and have them manage a portfolio instead of a human. It has been argued that Black Monday (1987) was magnified by portfolio insurance hedges, which were based on moving averages and trend following. This can create selling pressure that is detached from underlying fundamentals, which can be typical in most portfolio risk-management techniques as they are often driven by prices. This is not necessarily a bad thing but can create a cascade of selling that waterfalls and overshoots the economic reality. The main reason I bring this up is that the 200-day moving average of the S&P 500 was breached by the index last Thursday at the close, which could help to explain the two large down days experienced since that occurred. The 200-day moving average is arguably one of the most widely used measures for trend-following by most retail quant-investors. When you start out with quantitative portfolio management techniques, this is one of the first metrics you are taught to use to manage risk and time the market since it is simple and easy to understand/implement.

Review of Market Environment

As of the date I am writing this, the unemployment rate is still below its intermediate term trend (positive) and the stock market just crossed below its 10-month (200 day) moving average as of last Thursday (3/5/2020). So, for the time being, we are still in what we would characterize as a non-recession drawdown or market correction, albeit at a higher degree of severity than what is typical.

While this indicator is far from perfect, it helps by giving us a framework and lens to view the market through. The main point here is that a collapse in stock market prices without an underlying collapse in the economy happens far more frequently than most people can handle but tends to recover if the economy is not experiencing a recession. We are data-driven, and many pessimists will try and argue that we are in a recession or are going to be soon, our preference is to see it show up in data before drawing our conclusions.

Conclusion and Takeaways

All through time, people have basically acted and reacted the same way in the market as a result of: greed, fear, ignorance, and hope. That is why the numerical formations and patterns recur on a constant basis.
~ Jesse Livermore, How To Trade In Stocks

Over the last several years, I had the benefit of working very closely with two extremely talented behavioral finance experts, Richard Peterson, MD (www.marketpsych.com) and Frank Murtha, PhD. The most useful concepts they taught me involve managing investor emotions with techniques focused on improving emotional communication for a variety of emotional states. A lot of it is counterintuitive, so I think it would be useful to share some of the pertinent information for today’s market environment.

I will focus on two of the emotions referenced from the Jesse Livermore quote from earlier, greed and fear. While everyone exhibits varying degrees of greed and fear throughout life, it is how you react to these emotions and let it affect your decision-making that ultimately decides the direction and magnitude of the outcome.

When recent stock market performance has been strong (like the US stock market in 2019), investor behavior begins to exhibit more greed than fear. This leads some investors to over-extend themselves by taking more risk than they should (from over-stating their own risk tolerance to using leverage). When fear begins to dominate investor behavior, especially after a period of greed, investors overcompensate and take less than optimal amounts of risk. This can help to partially explain some of the boom and bust cycle and the effect on the stock market prices.

Which one dominates the market at any given moment is typically driven by a catalyst (positive or negative) that spreads to the majority of investors. This is useful for two reasons:

1. Avoiding individual investor errors by understanding which emotions are dominant when making decisions.
2. Understand which may be dominating the market, so you can avoid making the same mistakes as the masses.

Investing errors caused by greed and fear are magnified by uncertainty, inexperience, and disorganization.  These errors are more common when we:

• Are uncertain about the significance of market or investment-related information.
• Are inexperienced with the current market environment or investment type.
• Have an untested, disorganized, or incomplete investment plan.

Fortunately, a good financial advisor can help with all three which goes a long way when trying to avoid negatively impacting your goals and plans for the investment proceeds.

 

The views expressed are that of IFP and are for informational purposes only and in no event should be construed as an offer to buy or sell securities. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors.