Pandemic Panic: A Rational look at the Markets
It was a crazy week in the markets. A true black swan arrived and the uncertainty around the pandemic caused markets to panic. I’ve tried to make some sense of it and I thought I would share my thoughts, right or wrong.
A quick review of events and the “state” of the markets before Monday:
The major stock indices decline 10%+ last week.
The downward move was unprecedented in its rapidity, however, it was a very orderly decline; there was no 2010 flash-crash.
The market “word cloud” I’ve published in the past is all about the virus, not one mention of HFT as the villain.
The election volatility “premium” (this deserves a separate post later) dropped.
Stocks got a lot cheaper relative to bonds on a number of metrics; a typical 60/40 portfolio will now be 55/45 and should be rebalanced.
The Dow is back to 2018 levels, mainly due to exposure to major energy players.
Oil and Energy players, which were weak going into this week, are now in deep value territory.
Fixed-income assets did exactly what they were supposed to and provided a great hedge to stocks; they are now at 2016 yield levels.
MBS spreads have started to blow out; Credit spreads remained stable.
10y TIP breakevens show a forward inflation rate of 1.53%
The 2y-10y curve spread is still at 19 basis points; not inverted!
The 2010 HFT flash crash had a much higher VIX level.
The Vix futures curve is in major contango.
Some energy assets, like MLP’s, now yield as much as 20%! Again, deep value territory. I’m reasonably certain the world will need natural gas and oil.
Why did the Novel Coronavirus cause the markets to panic? In short, linear thinking. There is so much information today it is actually more difficult to find the information you can trust. That swarm of information makes it easier for fear to spread than truth. When you add an already slightly expensive market, election uncertainty, and some quick linear extrapolations of the data, people hit the sell button first and ask questions later.
There are two paradigms to think about in this situation. The 1987 market panic and the 1918 Spanish flu. In 1987, it was difficult to pinpoint the cause of the sell-off. The markets were in a similar yet different state. The US was primarily an industrial economy, so PE ratios were lower, and interest rates were quite high, but falling. Now, we have a similarly strong economy, higher PE ratios since we have a knowledge-based economy and much lower interest rates. The major difference is the virus definitely was the spark for the sell-off. So is it a good comparison? Mostly, but imperfect.
The 1918 Spanish Flu was a humanitarian tragedy. Millions died. It got its name because the first country to report the truth was Spain; other European countries spread disinformation due to WWI. It took two years for the pandemic to pass and it may have been exacerbated by the use of aspirin overdoses (aspirin was a new wonder drug then and overdoses cause Reyes syndrome). How did the Spanish flu pandemic pass? It mutated itself out of existence.
Like SARS, Bird Flu, and now Corona, Spanish Flu was believed to emanate from China; the density of people and animals in Asia make it much easier for viruses to mutate and cross from animal to human. None were man-made.
What is positive in this situation? Well, first we need to understand that linear thinking does not work very well. Growth rates that begin exponentially tend to dramatically flatten off as we change our behavior in response. This is called Farr’s Law. We are actually ALREADY seeing this in the data. So, while the information overload we have in today’s world is far from perfect, the rapidity in which information spread has had a positive impact.
What data? The WHO is doing a fantastic job making the data public multiple times each day on this Github site. Please follow that link. If you look at the plots below, the overall confirmed cases and the growth rate, you can see that the growth rate for all cases is around 3%. And if you break out each country you’ll note initial growth rate spikes followed by a dramatic slowdown and flattening. The notable exception is Iran.
Another positive, capitalism is kicking in. At last count, I found no less than 18 pharmaceutical companies hot on the trail of a vaccine. And while the normal time to market is 18+ months, I have to think a Coronavirus vaccine would get expedited through the regulatory process. My guess is that within weeks we’ll see positive news this front. 7.7 billion multiplied by a couple hundred per shot is lottery ticket each company would love to punch.
The final positive, the markets are pricing in an FOMC rate cut, and you have to remember this virus did not destroy economic activity or demand, it simply delayed it. Yes, it will disrupt supply chains, airplane flights, vacations, TV’s from Korea, but as we adjust to the virus (Farr’s law!) that economic demand will come roaring back.
When the market panics investors have some pretty clear choices: Buy, Sell, do Nothing. True value investors now have the opportunity to show their mettle.
The models I use to manage my investments were worthless when this panic hit. Nothing in my fancy math had "virus pandemic" baked into it. But, now that the storm is here those same analytics give me the ability to hopefully better judge the state of the markets and rationally navigate the rough waters.