As the Coronavirus disease is spreading around the world, rising uncertainty about what can happen next is translating into dropping stock markets and increasing fear for a worldwide economic recession.
How to invest in this scenario?
Volatility reached high levels not seen since the global economic crisis and monetary policy already stepped in to try to help the economy in this uncertain environment by cutting interest rates by 0.5% on the 3rd of March.
The markets are pricing 100% expectations for other rate cuts inf the at the upcoming Mar. 17-18 FOMC meeting, however the economy will need a medical solution since monetary and fiscal policies cannot fix the underlying problem.
Is it the beginning of the recession that by now many take for granted? It is possible that the spread of Coronavirus will be the catalyst of a crisis but it isn’t certainly the primary cause in the overall economy.
In this scenario, it’s likely that central banks will do whatever they can to avoid any slowdown.
The stock market is pricing the risk and started to crash, will it crash further? We will see what happens next but as an investor remember that, especially in the short-term, stock prices can go anywhere and what appears to be negative can indeed represent a huge buying opportunity for those who know what they are doing.
In this article:
- The worldwide spread of the Coronavirus COVID-19 disease
- The issues for the economy and potential causes of recession
- Assumptions, emotions and expectations of financial markets
- Central banks and interest rates cuts
- What central banks can do to address the situation?
- An overview of the economy and where we are right now
- Stock market crash? How to frame it properly
- Stock market crash behavior
- Long-term investing and big opportunities ahead
Coronavirus Outbreaks All Over The World
The Coronavirus COVID-19 disease is rapidly spreading around the world. The fast-moving infection originating in China has spread to more than 80 countries and governments around the world are stepping up efforts to tackle the virus that originated in China’s Wuhan city.
The World Health Organization (WHO) has declared a global health emergency given that About 80,700 people in China have been infected with coronavirus since its emergence and 18,000 cases outside China have been reported.
This chart shows the number of cases of Coronavirus outside China, you can find the updated version here.
Since I am not a doctor, I can’t really say much about the infection, however as an investor, I can’t ignore the fact that the outbreak of Coronavirus is really a black swan for the whole world. In the last couple of weeks, the situation is doing nothing but worsening and it seems that there could be serious economic implications.
Surely this is true for the short-term. Take a look at this chart:
Satellites operated by NASA and the European Space Agency have detected significant drops of major airborne pollutants above vast swathes of the country. In fact, lockdown measures to minimize further coronavirus infections.
The Coronavirus Black Swan
In a short time, the spread of the virus affected financial markets worldwide paving the way for a large number of rising uncertainties that can constitutes a tangible threat for the economy if fear and all prevention measures stay in place for long.
From a financial perspective, this kind of event is a well-known type of risk (or at least it should) to which all investors are exposed.
The risk I am talking about is a black swan, a rare and unforeseeable event with a huge impact, impossible to predict and with uncertain consequences.
The fact is that nobody really knows what the long-term consequences of this Coronavirus infection will be, what negative effects it will have on the economy, on politics and society.
This type of risk that is inherent to the investing activity. However, if we are in for the long-term, we should frame the issue with the right perspective.
Right now, many take a recession for granted. That does not surprise because markets are kind of on/off in their valuations: they are either “everything is great!” or “Panic! Sell Everything!”.
Coronavirus is around since December 2019 but if you take a look at the S&P 500 chart, nothing really significant happened until the end of February, when finally the market priced the risk all at once recording the 5th worst weekly performance in the history of the index.
Don’t get me wrong, the spread of Covid19 around the world IS an issue. First and foremost, it is a health and social issue, that is progressively showing its effects on the economy.
However, we shouldn’t base our assumption for the next 5-10 years based on what happened in the last two months, which is exactly what financial news are doing (by the way, their job is mainly to sell panic and destruction in order to get attention)..
A key role in the economy and financial markets is played by expectations. Now, expectations change every moment throughout the day and a ton of psychologic biases are involved in how they are formed.
However, given they relevance, they can’t be ignored. This what I think is one of the main reasons, if not THE reason, that prompted the fed to cut interest rates on 3rd March.
Central Banks, Interest Rate Cuts and Coronavirus
On the 3rd of March 2020, just four days after the release of an unexpected note, the Federal Reserve took the leadership of the response of central banks to the coronavirus challenge, cutting interest rates by 0.5%.
Chairman Jerome Powell said the Fed cut rates after officials appraised that the virus was affecting the economic outlook in a material manner.
“The magnitude and persistence of the overall effect on the U.S. economy remain highly uncertain and the situation remains a fluid one,” he told reporters. “Against this background, the committee judged that the risks to the U.S. outlook have changed materially. In response, we have eased the stance of monetary policy to provide some more support to the economy.”
However, following the cut, the stock market reacted with an increased volatility that reached extreme levels, levels that weren’t around since the 2008 global financial crisis. It seems that the marked priced the fact that rate cuts won’t “insulate it against supply-side concerns” and push stocks higher no matter what.
This move is huge, considering both how intense the cut was and how fast it came. But it could be just the beginning.
While many hoped that the rate cut may inspire an immediate bounce, there is no such evidence and the Federal Reserve Jerome Powell hinted at the possibility of a rate reduction at the upcoming Mar. 17-18 policy meeting.
The stock market is already reacting as if a drastic rate cut is guaranteed. The CME FedWatch Tool indicates that markets are expecting another huge rate cut with a probability of 100%!
We should take into account that historically the Federal Reserve has always succumbed to the will of the market when the probability is higher than 80%.
However, what central banks can do to address the situation?
Well, I think very little. The economy will need a medical solution to the outbreak to recover, monetary policy is not optimized for addressing shocks like this and the Fed cutting rates is not going to encourage everyone to travel, to consume or get back to work.
While monetary policy tools can help to foster capital markets and support some economic activity, they cannot do anything to slow down the spread of the coronavirus, nor can they alleviate people’s fears of the disease.
It is a public health crisis first and foremost, traditional economic measures like tax cuts and looser monetary policy, cannot fix the underlying problem.
The Fed has already been playing a dangerous game by propping up capital markets through rate cuts and liquidity injections. Every time that rates are cut, the room for maneuver is reduced.
This means that by focusing on the short-term financial markets and economic issues, the central bank is exposing the whole economy to potential more painful diseases should a big recession come.
In the end, what are the long-term implications for the economy?
Is it the Beginning of the Recession?
The economic disruption from the coronavirus has already been substantial. While I can’t predict exactly what will happen, a more severe the pandemic disease and a longer period of emergency could lead to a more prolonged disruption and recession.
Shutdown of economic activity across the world has an enormous impact on the whole value chain. This already happened in China, the world’s second largest economy.
The coronavirus may wipe out corporate growth in 2020 and eventually cripple the stock market. That’s why the OCED lowered global economic growth forecasts and many analysts are slashing earnings estimates.
Let me ask you a question: would you be surprised to finally see a recession?
I say finally because if you look back at the path we walked to get here, you see that we are in the longest bull market in history after 12 years of almost uninterrupted economic growth.
Give the fact that nothing last forever, a slowdown in the economy would be natural and we should expect it even if might not be desirable.
The spread of Coronavirus might be labeled as a catalyst of a situation that was already towards the end of the cycle. Back in January 2019 I wrote an article titled “Are You Ready For The Market Crash” (you can find it here) pointing out to several elements of risk and indicators for a potential trend inversion, among them, the inverting yield curve, crazy high market valuations and the huge amount of debt in the system.
Indeed, one year ago, there were lots of signs that pointed toward a major downward movement. While the market hasn’t crashed yet, I would say thanks to fiscal policy and the change of the Fed from tightening to cutting rates, the conditions in the economy remain the same.
Recessions and financial crisis don’t happen by chance, they are the results of a chain of causes and effects. In the last decade or so, we saw a massive use of debt to boost economic output and foster economic growth.
The levels of debt (governments, companies and consumers) in all the developed economies exploded in the last decade, this has been going on since the global financial crisis, but the point is that it will inevitably leads to even bigger problems in the coming years.
Have the “coming years” came today?
Maybe, what we know is that using debt to stimulate the economy can be done only for a certain period of time.
The mechanism works like this: a self-reinforcing cycle of more debt → more spending → higher economic growth → more employment.
The fact is more debt works until it doesn’t work any longer. By definition, through the use of debt we are pulling tomorrow’s prosperity into today, when the economy reaches a limit and can’t accept a higher level of debt the cycle reverts and works in the opposite direction causing a recession.
We find ourselves with a monetary system is either expanding or threatening to collapse, that’s why central banks do whatever they can to avoid any slowdown.
While we tend focus on the short-term news like the FED announcements on interest rates, the number of new jobs created, international trade, the level of GDP, etc., we often forget to consider a long-term view based on how the economy works and how people behave.
Every time that there is a scenario that could be a bubble or shows something that we don’t really like we find all sort of explanation to justify that “this time is different”, saying that what happened in the past no longer applies because of changes in technology, economy and society.
It was said so many times over the course of history and usually had never been the case, maybe this time could really be different, indeed it could be much worse than ever before.
Stock Market Crash
Will the stock market crash due to the coronavirus outbreak? Will the stock market crash due to lower quarterly earnings? Will the stock market crash together with a worldwide recession?
The fact is that it is a pure guess to time a potential outcome, subject to thousands of variables that we don’t even know how they will play out and interact.
Market crashes and correction happen (and it is not necessarily a negative thing, usually the opposite). If you want to be an investor you should take that into account. To some extent, the market is already crashing.
The key question is: are you concerned with a market crash?
When talking about that, one should keep in mind that
- Financial markets are always cyclical and tend to be short-term focused
- A recession will always happen, we just don’t know when and how
A crash and a recession could manifest in 2020, or maybe the economy recovers and goes on for another couple of years. Many predicted the recession by the end of 2019, and we should not be surprised that they were wrong.
Investors and economists have been predicted a financial crisis for 10 years, it didn’t show up and this shows that it costs a lot to time it wrongly.
Honestly, I think you will agree with me if I say that the market is noisy, is has always something to say that is 99/100 is focused on the next quarter and if you pay too much attention it impairs your ability to make a wise decision and brings you to information overload.
Keep in mind that your goals and expectations are different than market goals and expectations. The market behavior in a big average of people that have different interests and objectives, that change over time.
Furthermore, market behavior, especially over the short-term, is heavily influenced by emotions and several psychological biases.
Everyone gets excited and confident when his investment decisions are performing well and gets disappointed when things are not going as expected. The market sentiment can change dramatically over short periods of time because of emotional patterns that change depending on the conditions of the market. This emotional pattern occurred many times in history and is the plot of every bubble and subsequent market crash.
You know what? This is a BIG OPPORTUNITY for you to progressively get in the market.
During a downturn, when things start getting bad, investors and fund managers want to take the way out as quickly as possible, and if panic takes over people reach the point where they sell at any price.
When emotions are high, intelligence is low. In moments of fear an maximum uncertainty, stock prices can go anywhere and reach levels that have little or no connection with business fundamentals.
Anything can happen, so better be prepared for everything. Focus on facts that matter to your financial returns by knowing what you are doing and managing risks.
Price itself, doesn’t tell you anything about the quality of the underlying business, it’s just whatever someone is willing to pay for it today.
Successful investors seek for value in the business and develop a long-term view on the potential scenarios for the business, not the stock price.
We all know Warren Buffett, he expressed this concept in a very clear way in the 1993 letter to shareholders:
“In the short-run, the market is a voting machine – reflecting a voter-registration test that requires only money, not intelligence or emotional stability – but in the long-run, the market is a weighing machine.”
We currently live into an environment of information overload and the internet helps to amplify it. That could easily push us into making an irrational move. Realize that you don’t need most of what you hear to make your investing decisions because it is pushing you to make irrational moves.
If you are an investor and not a speculator, you can be easily unbothered by all that mess. We have seen stock market bubble bursts before, we have seen that several times. It can happen again and will happen again
Empirical evidence suggests that in situations like the one that we are approaching we can find substantial differences between price and value of stocks.
Look at the market objectively and keep your mind cool “while the world seems to be falling apart”. Go beyond market price and focus on the true value of the business, the stock price changes every day and doesn’t necessarily reflects the true underlying value of the company.
If you invested into a stock that has a long-term growth potential and good business perspectives, why on heart should you care about what the market has to say about the next quarter or so?
Do some research, figure out what the company is worth, spot the difference between price and value and act rationally upon that. Decide in advance what to do in every scenario in order to avoid acting emotionally whatever happens on the markets.
In the end, if you are an investor, you should not fear market crashes because they provide extreme buying opportunities to increase your long-term wealth.
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This article is for informational purposes only, it should not be considered financial advice. You can read the full disclaimer here.