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How to think in the eye of the storm

In the midst of the corona situation – another major turning point or a blip in the curve?

The reason for writing this up is mainly to walk people through the Corona situation and how it has impacted and will impact financial assets. I have discussed this issue with many people and spent a significant amount of time reading up on the issue. And the aim is to provide some high level thoughts that can prompt some thoughtful action to help combat investors’ cognitive biases at a difficult time. Also, there is a significant number of investors that have never suffered a major downturn and made lots of money since 2008 due to an upward trend in the market. This is something that might cloud one’s judgement and make investors brush off a threat as a blip in the curve and assume markets will go straight up again (like they have in the recent years). The corona virus might, however, not be that blip. As a matter of fact, it is very likely not a blip in the curve.

Context – the financial markets before the outbreak

The situation in the financial markets prior to the outbreak in Wuhan, China (early 2020) was kind of fragile in many markets among different types of asset classes. What we experienced in late 2019 and early 2020 was an asset inflation where all financial assets rose (e.g., stocks, commodities and to some extent bonds) in value despite modest growth prospects in the western world. More importantly some indicators in the real economy showed few signs of actually improving – especially the speed with which these indicators changed.

With this backdrop how do the financial markets tackle an exogenous shock with a huge potential to hurt both the economy both in the short and medium term?

In the very short run the markets just sell everything associated with any type of risk – this includes most financial assets. This includes assets that are normally seen as “safe havens” such as bonds and gold (e.g., the gold price also went down quite a bit due to the market turbulence). The main reason for this is because investors need to cash partly to pay off debts and partly since cash, arguably, is the only real short term safe haven. What also happens in such a turbulent time is that the market tries to find a new equilibrium price (simply put where demand equals supply) for financial assets. For instance, the market starts to question the valuation of all stocks – and simply asks what P/E ratio (i.e., how many times you pay for one year’s profit after taxes) should be for stocks in general. My view is that stocks that command a very high valuation will be repriced, which will lead to significant drops in market values. Simply put, the market might decide to reduce a company’s P/E 40 to PE 20, which means the company’s value is halved. This happens due to multiple factors such as economic growth prospects and risk sentiment. In this case one should pose the question – what is the likelihood of an increase rather a decrease in valuations in 6-12 months?  

This initial selloff was in European assets and has not been as fierce in the US (this might have started already). Once we see a big selloff in the US, the rest of the world will most likely be pulled down even further and suffer as much as, if not more than, the US markets. This will likely be driven by a flight to safety and huge withdrawals/ outflows from ETFs and mutual funds that result in yet another downward pressure on asset prices. This ultimately leads to a vicious downward spiral that accelerates the downturn. Once that is done one can pick up assets at bargain prices. So, when will the Americans really sell? Well, probably once the virus has spread throughout the US and is hard to control. Actually, we saw the beginning of that last week and it is likely to escalate. There is, however, a scenario that the policy makers will act forcefully to contain and control the spread of the virus, which will subsequently be rewarded by the markets. 

After the blowout in the financial markets, market actors as well as economists will try to dissect how the outbreak will impact the economy and the world in general. If the worst case scenario that needs to be priced in (such as an extended global pandemic) investors will surely be more prone to hold anything else than risky assets. Things do not need to get that extreme in order for market actors to price in the likelihood of a bad scenario (especially if they do not believe in policymakers’ actions). The markets are a voting machine that puts a probability on different future scenarios and apply different weights to these and subsequently value assets accordingly.

Finally, the corona situation long term will lead to some interesting ramifications on politics and trade that I can delve into in a future blog post.

A note on liquid markets

The good thing about owning assets in a liquid market is that you can sell as long as there is liquidity. After you have sold, you can even buy them back – preferably at lower prices. This, however, is only possible when there is a buyer of some of your assets. In the midst of a crisis there will be a buyer but due to reduced liquidity (i.e., buyers will prefer cash instead of stocks) and at a far lower price than some investors might be able to conceive. One can refer to other crises to get an idea of what I am talking about here.

How will this impact the real economy (my guess and some high level thoughts)?

So how will a global spread of the Corona virus impact the global economy in the short run? 

The first thing is obviously the disruptions in the supply chains due to the lockdowns in China/ Asia, which will impede its customers and partners all over the world. Secondly, tourism, travel, retail spending, spending on luxury goods will suffer due to the lockdowns elsewhere. Thirdly, companies might postpone investment decisions due to the sheer uncertainty caused by the outbreak. Even if an industry might appear unaffected, the outbreak will most likely impact the financial markets, which in turn impact all industries or at least their willingness to invest in new projects. The reason for this is because financial markets are often used as a proxy on the risk sentiment and willingness to invest in new projects.

Fourthly (and more long term), depending on what actions are taken this might lead to multiple changes that range from new public policy, political changes, trade policy and diplomatic relations. It’s too early to know for sure and time will tell what the long term consequences will be and so I will refrain from speculating too much here.

All these things will be priced in in the next few weeks by the financial markets, which will ‘guess’ how gloomy the future short to mid term prospects are. This is why we will most likely experience some market turmoil as we get more data and actions from governments around the world.

Probability of different types of scenarios for the stock market

A way to think about it is to use basic math to decide on what will happen going forward. Simple probability can be very useful when thinking about this. The following 5 scenarios are just made up numbers but is roughly what I use to assess this situation:

10% probability that stocks will be trading at much higher in 12 months

10% probability that stocks will be trading at higher in 12 months

20% probability that stocks will be trading at roughly the same in 12 months

30% probability that stocks will be trading lower in 12 months

30% probability that stocks will be trading much lower in 12 months

This is obviously not an exact science but this can be used as a mental model when making an investment decision (or any decision for that matter). If the likelihood of stocks trading much lower in 12 months, one could just opt to sell and buy back. The key takeaway is to have this in the back of your head once you are faced with an investment decision. Furthermore, one should always be prepared to reassess the probabilities to any given scenario.

Some thoughts on the so called “domino effects”

Something investors need to be mindful about is that, at all times, our own opinions about a stock or a company matter very little. On the contrary, it is the market’s collective opinion we need to be mindful about – the market prices all assets and its future prospects, which we can choose to buy or sell. What we can do is to try to peer into the future and estimate the second and third order effects of a scenario. Since that is what markets really do. Let’s use the ‘corona crisis’ as an example – the second order effects of a crisis will most likely be that retail spending decreases, traveling is curtailed, some other spending increases temporarily and even a few quarters of recession. The third order effects might be the companies that are contractors in those affected industries, or the fact that investments in seemingly non-affected industries are impacted due to an increased uncertainty or even that a new political party wins popular opinion. To think along these lines and to be humble to the fact that one always needs to be nimble and reevaluate the probabilities of said scenarios especially in these rather uncertain times. Note that this is an abstract mental model one can use to assess the consequences of any given scenario that will help you looking into the future.

Conclusion

When market conditions change drastically it should give you a signal to change/ adapt your behaviour (i.e., strategy) as an investor as well. Perhaps the good old buy the dip and hold strategy is not always the most suitable for a given scenario? Or perhaps it is! To simply go back to the good old “markets will bounce back” is a flawed statement since that omits when markets will bounce back. Another way to think about it could be – if the value drops by 50% you can then buy back 2 of the same stock for the same price and in the long term you will have accumulated MUCH more capital. This rational argument or strategy is the one I have tried to use in practice – i.e., always be rational and never fall in love with the assets and keep them for the sake of keeping them. Feel free to do the math on this – it’s an eye opener!

A few future thoughts every investor needs to ponder in the eye of the storm

  • When do I need the money? 
  • How much am I prepared to comfortably lose until I decide to sell? Or put another way how would you feel once the entire portfolio shows -50%? This is hard. In fact, it is very hard to imagine but one should nevertheless try! 
  • Why am I reluctant to sell? Is it FOMO (fear of missing out) or is it perhaps the fact that I am emotionally attached to something I own and assign a higher value to it (i.e., endowment effect)? 
  • Why do I dabble in investments? Is it to make money or to “be right”? Some people care more about the latter. Or is it something else? So, have a think about why you spend time investing! 

So when should you buy stuff again? That is indeed a topic for another day!

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