On 11 March 2020, the World Health Organisation (WHO) officially categorized the COVID-19 Virus as a pandemic. South Africa has seen a jump in confirmed coronavirus cases in the country, with the total now at 709 – up 152 from Monday’s report, said health minister Dr Zweli Mkhize. On Monday evening President Cyril Ramaphosa announced a nation-wide lockdown that will begin at midnight on Thursday 26 March, and will continue for 21 days.
The COVID-19 virus has been affecting the global economy. Markets have been crashing. There is a lot of fear and panic right now… Let’s take emotion out of the equation and break down the impact of this epidemic on your investments.
Stock Prices And Falling Markets
Stock prices reflect investors expectations about future profits and risk when those expectations change as they do frequently.
Prices change and they can change dramatically. Volatile stock prices do not mean that the market is broken or that the world is ending. Sharp price declines are expected from time to time in an efficient stock market, and their inevitability should be built into every investment plan. I think that most people understand this, but there’s a problem. Every market drop feels different. There is always a narrative and the narrative is often scarier than the drop itself. If we can understand the power of a compelling narrative to make us behave irrationally, we might be better equipped to make better decisions and feel less anxious when the stock market does decline.
Data And The Impact Of Narratives
To get through periods of market volatility, we need two pieces of mental equipment. We need to understand how we as humans are wired to behave and we need to understand what the data say about market drops. Being aware of both the data and the impact that narratives can have on our behavior should help us make more rational decisions.
Narratives can be extremely powerful through the framing effect. They can change the way that we see facts. And through the representativeness bias, they can cause us to ignore base rate probabilities while drawing parallels between our current situation and familiar narratives. A narrative does not change the facts of a situation. But it can easily change how people respond to the facts. It’s important to remember where this information is coming from.
Robert Shiller is the Yale economist who won the 2013 Nobel Prize in Economics Sciences for his work on bubbles in asset prices. Shiller defines a bubble as a social epidemic that involves extravagant expectations about the future. It is not hard to see the connection between narratives and their potential effect on asset prices and the economy as a whole. Shiller explains that narratives may have played a role in some of the biggest economic events of modern history.
Example: The Great Depression of 1920
For example, in the 1920 to 1921 a US recession.0 The narratives were grounded in terrible recent events. World War 1 had ended 14 months prior. The effects of the 1918 influenza pandemic were still lingering. The US had been dealing with race riots and a public fear of communism was growing combined. These are the basis for an unsettling narrative of economic uncertainty. To top all of that off, US oil prices jumped 50 percent to between mid 1919 and the end of 1920. The dominant oil narrative was that the demand for oil was outstripping supply due to the increasing uptake of automobiles. The nation’s oil supply was expected to be depleted within 18 years.
Looking back now, we know that didn’t happen because we found more oil. But you can imagine how that narrative might have affected expectations about the future. At the time, based on how the world looks right now, the influenza pandemic of 1918 is particularly interesting. The 1918 flu is estimated to have killed six hundred and seventy five thousand people in the United States and 40 million people around the world from the spring of 1918 through the spring of 1919. Males aged 18 to forty were hit the hardest between the sparse available economic data and anecdotal evidence from newspapers.
We cannot say with certainty if the recession that followed was caused by the flu or the confluence of other factors. But we do know that the S&P 500 is cyclically adjusted. Price earnings ratio dropped to its lowest level in history in December of 1920. That would have hurt. But guess what happened next? Asset prices came screaming back up. To be fair, they did fall sharply again in 1929. But guess what? They rebounded again afterward, although a bit more slowly. The second time you might be thinking that’s a clear case of survivorship bias.
We can’t assume that all market crashes will be followed by rebounds just because that’s what we’ve seen in the US. Well, do I have news for you? The phenomena of markets bouncing back after crashes was studied by William Goldsman and Dessau Kim in a 2017 paper titled “Negative Bubbles. What Happens After a Crash?” They studied stock market crashes from 101 global stock markets from 1692-2015 and identified 1032 events where a market declined by more than 50 percent over a twelve month period. They found that the probability of a large positive return was higher following a crash.
They note that following a crash, investors tend to decrease their allocation to stocks. But based on the empirical data supporting rebounds after crashes, reducing your equity allocation after a crash might be the worst thing that you can do. Remember, this large empirical data set is immune to any narratives. When we observe in each of those 1032 crashes, we’re probably accompanied by intimidating reasons to expect worse things to come. But we can step back and observe the outcomes free from the accompanying narratives. Knowing that the data on market crashes going back to 1692 suggests that sharp declines are usually followed by large positive returns.
What Will Happen Now?
We as investors have some challenging decisions to make during times of market turbulence.
If we get out of the market to avoid a drop, we also need to get back in. Getting back in at the wrong time might mean missing out on the rebound gains. Take the S&P 500 going back to 1926 through the end of February 2020. As an example, it had a compound average annual return of 10,08% in U.S. dollar terms over the full period. If we remove the top 10 monthly returns, that’s the top 0,9% percent of months in the full period, the annualized return drops down to 7,4%. But here’s the tricky part. Most of those top returning months occurred during or after big drawdowns. If you got out, you probably missed out.
What If I Loose All My Money?
If the alternatives were the chance of missing out on some of the best monthly returns by timing the market or losing all your money permanently, I could see how timing the market wouldn’t seem so bad.
But let’s think for a moment about the concept of losing all of your money in stocks. When you buy stocks, you’re buying ownership of expected future earnings from real businesses. You pay a price for those earnings based on how risky the businesses are. When stock prices drop, it means that expected future earnings have decreased.
To lose all of your money in a diversified portfolio, we would need to be in a situation where nobody expects any business to earn any profits in the future. This is an extreme case and it does seem fairly unlikely. A more realistic set of alternatives might be the chance of missing out on some of the best months by getting out of the market too soon.
This is where narrative’s and asset allocation become equally important. Narratives will make us believe that this time is different. But challenging and uncertain times are nothing new. Just this century, and it’s still a young century, we’ve seen the dot.com crash, the 9/11 attack on the World Trade Center, Ebola, the swine flu, SARS virus, the global financial crisis and the start of COVID-19.
Your Strategy Going Forward
Narratives are powerful and often important, but they can affect the way that we interpret facts. I think that it’s important to step back and look at the broader set of data on what happens after market drops before responding to a decline in stock prices, regardless of the narrative. You should be invested in an asset allocation that you can stick with in both good times and bad. Getting out when things get bad is one of the best ways to sabotage your persistently positive expected stock returns.
The market has responded by pricing in lots of new knowing information and lots of big unknowns. Uncertainty increases risk driving down asset prices and driving up expected returns when the market declines. It’s not time to get out. This is when equity investors earn their equity risk premium.
I am not saying that this won’t be hard. The market might keep dropping and after each subsequent drop, the decision not to sell after the previous drop might seem increasingly regrettable. But remember, everything is obvious in hindsight. On any given day, including after a market drop, the best thing that we can do is stick to the plans that we made during calmer times. The economy might take a big hit, but this is why you had an emergency fund. Stocks might continue to drop, but this is why you invested in a risk appropriate portfolio.
It can be challenging to make good long term decisions. This is why you made a plan and now is the most important time to stick to it.
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