Forget that the major US stock indices eked out a small gain last week. All that most investors will remember is a wild week that took their portfolios on a harrowing roller coaster ride - one that prompted a respected financial television anchor, Jonathan Ferro, to remind his viewers that the market fluctuations they were seeing were not "one month or even one week moves but, instead, one day moves!"
This weekend's news about the further spread of the coronavirus points to the possibility of another volatile week, especially as policymakers scramble to catch up with the economic and social damage being inflicted by the virus. In contemplating this unsettling outlook, investors may wish to remember the following six things:
First, volatility is partly due to a tug of war that won't be resolved anytime soon.
At one end of this tug of war, the corononavirus is causing economic disengagements and will fuel a series of awful economic data reports, negative corporate earnings revisions and financial distress for some companies. These cascading economic "sudden stops" involve a phenomenon that's extremely rare in advanced economies: simultaneous supply and demand dislocations.
Take the cruise industry as an example, albeit an extreme one, of a self-feeding cycle of demand and supply destruction that also has unfortunate negative spillovers. With all the media reports on infections and quarantined cruise liners, including the ship stuck off the coast of northern California, tourist numbers for new cruises have collapsed. In response, companies have grounded ships and laid off thousands of employees, whose lost income will mean less spending.
Second, it's not easy to restart an economy, even after an all-clear medical signal.
This is not just because of highly interconnected economies in which an effective restart requires a critical mass of synchronization and coordination. There are also tough managerial decisions that need to be made on a timely basis, with the high risk of others (including lawyers) second-guessing the management team (or worse).
As an example, imagine that you are the CEO of a company that, for precautionary reasons, has imposed a travel ban on employees: What would you need to make you comfortable enough - internally, externally and from a legal liability viewpoint - to lift the ban?
Third, the economics of fear makes everything worse.
Even when analytical risks are objectively low, fear has a way of amplifying the negative economic and social effects of the uncertainties that comes with a new illness. With misinformation and exaggerations also making things worse, most people will err to risk aversion as they get taken further out of their comfort zone and normal operating routines. Travel, conferences and festivals are cancelled out of precaution, adding another layer of paralysis to economies already suffering income losses and supply chain disruptions.
Fourth, periodic market relief is likely as governments around the world step up their efforts to contain the spread of the virus and counter its multiplying negative effects.
Having initially underestimated the impact of something happening far away (and just in China), advanced countries are now scrambling to counter and defeat the virus. The immediate emphasis is on micro measures. These will soon be placed in a more holistic "whole of government approach." They are also likely to be supplemented by better global policy coordination. After all, it's a shared problem, involving collective responsibilities and needing coordinated approaches to minimize "beggar-thy-neighbor" problems.
The most critical area is, of course, medical advances to better understand this new virus, contain its spread, counter its effects, and increase immunity. Markets will tend to grasp bits of positive news, whether confirmed or not, to counter the stream of negative economic news. The reaction will be particularly pronounced if the news is related to vaccine development.
As governments increasingly commit to a "whatever it takes" policy response, markets will also deal with a deluge of measures aimed at protecting the most vulnerable segments of the economy and shielding some others from distress. But as illustrated by the markets' decidedly unenthusiastic reaction to last week's emergency 50-basis point cut by the Federal Reserve, the price consequences are likely to be more nuanced than in the past - and for understandable reasons.
Traditional measures, such as interest rate cuts and tax credits, may bolster corporate and household balance sheets but will do little to restore the confidence needed to re-engage in damaged economic activities. After all, how many of us would be more likely to take a cruise if we were suddenly granted a cheap loan or a tax refund to do so?
Fifth, the more central banks are seen as less effective, the greater the risks to the impressive rally that has powered stocks to one new record after the other.
Initial conditions matter. For markets, this includes elevated asset prices repeatedly decoupled from the underlying fundamentals by how investors have been conditioned by central banks over the last few years - that is, to bank on ample and predictable liquidity that represses market volatility, pushes stocks to new highs, and overwhelms long-standing market relationships (such as the negative correlations between "risky" and "risk free" assets - that is, stocks and government bonds, respectively).
The growing realization that "this time is different" risks shaking confidence in central banks' ability (though not willingness) to shield markets from worsening fundamentals. Already, there is less evidence of the BTD/FOMO ("buy the dip" due to the "fear of missing out") behavior that repeatedly drove investors to fade virtually any market pullback. The more confidence in central banks erodes, the higher the probability of asset prices converging quickly to the more sluggish fundamentals.
Sixth, market technicals and illiquidity amplify price volatility.
Given all that's in motion these days, we should also expect market overshoots due to the behavior of short-term traders operating in liquidity-challenged markets.
The likelihood of more negative news will attract short-sellers looking for the type of sharp price drops that turn nervous holders of stocks into panicked sellers at a time when market liquidity can only accommodate a small amount of selling. But when market sentiment periodically shifts, as inevitably it will, the upward price pressure will be turbo-charged by short-sellers scrambling to cover their positions, bottom fishers and agile day traders - again, in challenged liquidity conditions.
For much of the rest of the market, however, these overshoots will appear curious and puzzling. They are also likely to amplify the sense of insecurity and uncertainty.
As we look to the next few weeks, we will hope that rapid medical advances will make it possible to contain and, eventually, eradicate the coronavirus. But until we have better indications of this materializing, we should guard against what behavioral science warns is a considerable risk of panic and paralysis due to heightened uncertainty and insecurity.
To do this, investors would be well-advised to adopt simple framework to interpret a rush of information on the spread and consequences of the virus - a process that is equivalent to trying to drink from a fire hose. They should also follow the advice of Robert Koenigsberger, the founder and managing partner of the Gramercy investment firm, to "plan the trade and trade the plan."
In the case of the coronavirus, both defensive and offensive components are needed.
On defense, resist the urge to panic-sell holdings that are supported by strong fundamentals (high cash balances, viable debt structures, responsive management teams, and good management plans). These are likely to recover and do well over time.
On offense, consider a highly selective approach rather than just" buying the index." This would include picking up strong-fundamental names at cheap prices, looking for attractive opportunities in distressed debt and via attractively structured credits, and exploiting relative values and other bargains that typically emerge from generalized and indiscriminate market moves.
Published originally in Yahoo Finance on March 8, 2020.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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