We are getting a few questions from clients on the nature of the most recent stock market sell-off. We thought it would be a good opportunity to address these questions in our blog, so that all clients can hear our response.
Let’s start with the surprise factor. Was this week’s dramatic two-day pullback unanticipated? Not in the least. Analysts and commentators have been concerned about investor complacency for a long time. Markets have been steadily rallying over the last year, stoked by reassurances by the Federal Reserve and the reduction in trade war fears. The markets recently surged to all-time highs. From that perch, a pullback is entirely expected and normal.
A couple of statistics could be helpful (courtesy of Ned Davis Research):
- A moderate correction of 10% or more happens about once a year
- A severe correction of 15% or more is seen statistically every 2 years
- A “bear” market of 20% or more occurs every three years on average
However, it could be argued that this pullback feels different. The suddenness and pace have surprised some people. We would attribute this reaction to the fusion between finances and health.
- The magnitude of the 1910-point drop in the Dow looked dizzying and has been characterized as the biggest two-day slide ever. This is true in nominal terms for the Dow. However, in terms of percentages, the magnitude of the loss has yet to reach correction territory and paralleled a similar two-day slide in February 2018.
- In addition, 70% of Dow trading is driven by computers, which follow quantitative formulas often without the nuanced perspective of human beings. That means that the pullback can be seen less as a rationale response to news, but more a technical response to price changes.
- Moreover, a popular investment approach called momentum strategy (one where traders follow the direction and flow of money) can magnify any shift in sentiment. A reversal in direction can elevate the pace of investors adding or subtracting dollars from the markets.
- Taking together, quantum and momentum investors can introduce great volatility into the markets, divorced from an underlying fundamental cause.
- The coronavirus. Here is where the markets feel personal. The emotional response to the drop can be seen as “Not only could my money be impacted, but also my health”. Here again, we need to insert caution. It is highly unlikely that many of us will actually contract the coronavirus. Most communities in the US will likely avoid much, if any, exposure at all. However, because there are so many unknowns about the transmission of the disease, people are being warned to be ready (not scared) just in case their community is impacted. These precautions are seen as disruptive to daily lives and can serve as reminders that unknown risks remain.
We cannot predict the impact (if any) of the Coronavirus on our clients lives and we certainly hope that everyone remains healthy in the coming months. However, our Portfolio Management Committee can (and is) tracking the global economic effect of the disease.
Portfolio Manager, Derek Amey, wrote a detailed blog on February 5, 2020 discussing the implications of global supply chain disruptions and quarantines on certain sectors of the economy. If the Coronavirus acts like previous epidemics, such as SARS, MERS and Ebola, the life of the market pullback will be transitory, and the economy and the markets should rebound after a relatively short period of time. This is our current thinking, which means we believe our portfolios are well positioned to ride out this turbulence.
Our level of concern will rise, however, if the Coronavirus lingers and starts changing consumer and business behavior beyond a temporary basis. This could happen if the disruptions result in a more permanent closure of a sufficient number of businesses and/or a meaningful loss of jobs.
So, the answer to our clients’ question is – no, we are not concerned yet. However, we are very mindful that – like any period in history – sentiment, circumstances and markets are fluid and must be watched carefully.
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