The market is clearly not happy: the Standard & Poor’s (S&P) 500 is now down more than 18 percent from its peak in mid-February, and volatility abounds.
Let’s attempt to wrestle some of that uncertainty into some perspective. What follows is an update on COVID-19 and the markets, as well as some historical lenses through which to help view our current situation.
I would be remiss in not underlining the notion that we are not epidemiologists. While I now know far more than I had ever hoped about the difference between influenza and pneumonia-based viruses, we have no knowledge, nor belief, about how the virus will behave and how far the impact will stretch. And yet, history can act as a wonderful compass (if not a map) … and is particularly useful during the foggiest of hours.
First, let us begin with a quick update on the nature of the crisis. As of March 9:
- The novel coronavirus is now present on every continent except Antarctica, has infected nearly 112,000 people, and has killed more than 3,900 (the vast majority in China).1
- Italy, as an example, is now attempting one of the largest-ever efforts to restrict the movement of people, with a lockdown of roughly 16 million Italians in the North.
- In the United States, there are now a bit more than 560 confirmed cases and, as more testing kits are deployed, a number that is likely to rise.
As such, the market is understandably jittery. Those facts (and I wrote them) still startle me. Particularly when taken with the historically useful human penchant for “fight or flight” action, these statistics themselves can cause panic. This is precisely why it is good to pause in these moments. Those three items alone can explain a good deal of the recent market action, particularly when coupled with the other drivers of uncertainty. Market participants are scared, and many are beginning to act irrationally. Yet, if history has shown us anything, it is that humans are not particularly adept at making rational decisions during times of crisis.
Therefore, as market observers and students of history, we should attempt to objectively review what has occurred so far, with a keen eye toward separating fact from hyperbole. If done well, this should help us to make high quality decisions moving forward.
First, and foremost, let’s review the growth rate of the current crisis. Definitionally, for an exogenous health shock to wreak havoc (from a health perspective), it must compound at a high growth rate. As shown in Chart 1, the number of active cases continues to rise, and yet the daily growth rate is still moderate. While we expect this to rise as the number of test kits expands, it is worth noting that China is now touting its recent success and sending workers back to work and children back to school.
For perspective, it is also worth remembering that during the 2017-18 flu season, 45 million people were infected worldwide, and 61,000 people died.
Second, it is important to acknowledge that Central Banks around the world have begun taking a very accommodative stance. Why does this matter? Quite simply, they are striving to provide access to inexpensive capital (for evidence, look to record-low mortgage rates) and keep markets acting as they should.
It is important to remember that throughout history, the largest selloffs have occurred in the absence of that capital, and Central Banks are trying to ensure capital markets remain open. So far, capital is flowing freely, but we are watching this dynamic closely as it is a very important marker of whether this selloff will worsen.
Third, let us look to markets themselves. Chart 2 shows the S&P total return3 index since 1940 and highlights the most recent crisis when compared with other large selloffs. Perhaps obvious, but a takeaway is that with enough perspective, even the most dramatic and scary of events can fade with time.
Investors with low risk aversion that are now considering selling equities are certain to lock in losses and are likely to miss any future gains. Not only is this difficult (if not impossible) to time well, closing positions will likely also incur tax consequences, not to mention making re-entry into the markets even more tenuous.
Therefore, for a moment, let’s simply ignore the data, let’s ignore history and let’s ignore diversification.
Let’s simply think through what options we do have:
- Option 1: Stay the course. Ignore the short-term volatility.
- Option 2: Sell all equities and move to cash.
- Option 3: Sell all equities and move to bonds.
- Option 4: Sell all equities and move to commodities.
Option 1 relies on what plan has been put in place during calmer times. This trusts in the idea that, in the long-term, capitalism and its related markets are the best location for allocating capital and generating returns. This option benefits from diversification, minimizing taxes and lower transaction costs.
At first glance, Option 2 appears to take risk off the table. Yet when exploring further, Option 2 guarantees the investor is locking in realized losses in the equity markets and/or realized gains in the bond markets, which is just exchanging one type of risk for another. This will likely create a taxable event and will certainly incur transaction costs. The investor is then losing purchasing power on an ongoing basis as cash does not currently return more than inflation and the investor will not participate in any future economic or market gains. Lastly, this option may then woo the investor back after uncertainty has decreased and markets have recovered … which is generally the worst time to be re-investing.
Option 3 also seems like a reasonable move at first pass, except it would be re-allocating from an asset class that is now less expensive (as it has fallen about 20 percent), and allocating to an asset class that is very expensive (bonds are currently trading at 80-year highs). This is opposite of the investing principle to move toward cheap assets and away from expensive assets.
Further, 10-year U.S. Treasury bonds are now yielding far less than inflation, and far less than what equity markets have returned historically over any reasonable period. This is in addition to the tax and transaction cost impacts mentioned with Option 2.
I have heard Option 4 bantered about recently. At this time, we feel that commodities have no positive expected value, and thus there is economically no benefit to holding them (other than diversification). They also are incredibly volatile right now, and many are at recent highs. For example, crude oil has fallen 30 percent today alone, and gold is now at seven-year highs.
In summary, as investors, we are confronted with two truths:
- We are in the midst of an exogenous shock which could be accelerating or decelerating—no one really knows.
- To weather the storm we should focus on the long-term, avoiding emotional reactions and recognizing (and benefiting from) the power of diversification.
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1 New York Times, “Outbreak Strikes Seattle Area as Testing Is Scrutinized,” March 12, 2020.
2 Sources: Bloomberg, World Health Organization
3 Source: Bloomberg, note. This chart is shown in lognormal terms, which means a 12 percent return early in the chart shows up graphically the same as a 12% later in the chart. It is the proper method for displaying long-term data.