The Lessons Of Market Volatility 

Well, at least 2020 hasn’t been boring.

Let’s talk about something fun: volatility. 

In contemplating this unsettling outlook and the massive volatility swings, 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 coronavirus is causing economic disengagements and will fuel a series of awful economic data reports, negative corporate earnings revisions and financial distress for 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. With all the media reports on infections and quarantined cruise liners, 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.

And so the dominos fall.

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.

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?

Guess wrong and it’s your head.

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 uncertainty. With misinformation and exaggerations also making things worse, most people will avoid risk as they get taken further out of their comfort zone and normal operating routines.

Nothing says fear like hoarding toiler paper. 

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, developed countries are now scrambling to counter and defeat the virus. After all, it’s a shared problem, involving collective responsibilities and needing coordinated approaches to minimize the damage and death.

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, especially 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. 

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, are people more likely to take a cruise if they’re given 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. 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.

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 a 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. Essentially, “plan the trade and trade the plan.”

In the case of the coronavirus, both defensive and offensive components are needed with regard to making investment decisions, as we covered yesterday. 

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.

Hang in there and don’t let volatility be your enemy.