Weighing the Future: Coronavirus and the Economy

The decline in the stock market (as measured by the S&P 500 Index) since the top on February 19 exceeds 20%, a circumstance which by convention defines the end of the prior bull market.  The advance from the previous bear market low (March 9, 2009) saw the index rise from 676.53 to its peak of 3,386.15, an increase of 400.52%.

This second bull market of the 21st century lasted nearly eleven years, far longer than the 6.09-yr. average during the ten bull phases of the post- World War II era, and longer than any prior bull market during that period except the great boom which followed the war.

The annualized index performance in this long march was 15.83%, less than the 17.19% post-war average. But having run longer than a typical advance, the cumulative result during the teen years of the new century was exceeded only once before since the postwar boom.  

These bull market gains were a delight, but it’s likely that most of us didn’t take them to the bank.  Every bull market is followed by a bear phase, during which sizable and often sudden losses occur.  It remains to be determined how low the index will go in the current bear phase, and how long the decline will last.  The average post-war bear mauled the markets for 1.1 years (in a range from three months to 2.5 years), exacting a cost of nearly 35% (in a range of 20-57%).

The long-term index performance, including both ups and downs, offers a better indication of what investors might expect to achieve.  The entire postwar run, from the peak in May 1946 to the most recent top, saw the index rack up cumulative gains of 7.26% per annum.  The recent decline (through March 12) trimmed that result to 6.8%.  A regression trend line plotted through the peaks and troughs of the index performance confirms the realistic nature of this sort of expectation.  Investors who make long-term plans based on grander expectations are likely too optimistic.

Investors with long-term investing objectives should think twice about trying to time the markets, especially since the horse seems already to be out of the barn.  Timing successfully requires making two decisions correctly -- one to get out, another to get back in.  There is a high bar to success.

We know, based on postwar history, that the index has been in a bull phase more than 85% of the time, so the probabilities favor the “long” side. We also know that new bull markets typically launch recoveries with gains which are materially higher than the 17.5% achieved over the course of an average advance.  In the prior bull, beginning in March 2009, the S&P 500 Index gained more than 68% in the first year of recovery, and the performance in that period was skewed in favor of the early birds.

Another factor argues against any inclination to “trade” the market:  the volatility associated with stocks in recent years seems to have become more pronounced.  The media tend to talk about volatility as if it all occurs on the downside, but there is a better-than-symmetrical response on the upside.  A recovery can begin with a vengeance, in the midst of high volatility.  Market timers can be left flat-footed.

Increased volatility is a product of several factors, including the emergence of electronic markets, and the proliferation of news outlets which report and comment daily on economic and market events, as well as general news and information. The electronic age has collapsed the time it takes for people who are paying attention to make decisions.  If one is not paying close attention, one should probably make fewer decisions.

Another important influence contributing to volatility is the increased presence in the market of “technical” traders and arbitrageurs.  Such actors do not embrace the medium- to long-term horizon of typical investors, including institutional fund managers, but instead act to capture short-term price opportunities.  They are set up to do that, and have a trading cost structure and scale of operation which makes that a practical pursuit.  For most market participants that is not true.

This observation is not meant to disparage traders.  It’s a free country, and they stand ready to put their money at risk, with the objective of earning good returns.  Most of the time, their presence is beneficial to the rest of us.  The collapse of trading spreads is the best example of that.  It wasn’t that long ago that trading costs were quite high, with stocks quoted on 1/8th and ¼ dollar spreads.  These days our most liquid stocks are quoted with a one-cent spread between the bid and the offer.  The narrowing of that gap is in great part a result of the liquidity supplied by the trading community.  A price quoted on such a narrow spread reflects greatly improved liquidity, deep enough for most investors to operate without market impact.  That’s a good thing.  It reduces the cost to Main Street investors of participation in the stock market, whether directly or through managed products like mutual funds and ETFs.  But in the short run, some trading strategies can tend to exaggerate market moves.

The popular media often talk about “market volatility,” when in fact they mean market decline.  Talking heads on TV will cite the VIX as “the fear index,” with the implication that a high VIX portends rough times ahead.  Not so. The VIX is a measure of implied volatility derived in real time from the options markets, based on the premium over intrinsic value at which both puts and calls are trading.  Volatility is also manifest on the upside, and the VIX will reflect that when sharp advances occur.  Make no mistake, a high VIX today has zero predictive value about the market level in the future.  That much is clear in the data.

At the present moment, market participants are expressing fear, uncertainty, and doubt (FUD) about the price the latest coronavirus will exact from us.  The efficiency of and ease of access to the stock market gives us an easy and quick way to manifest our anxiety.

We should understand the sharp stock market decline as an acknowledgment that business fundamentals have changed for the worse, at least for a while. The “social distancing”, reduced travel, lost work days, and quarantining needed to inhibit the spread of the virus will likely impair economic activity in the current quarter and the next, perhaps longer.  A recession, understood as a decline in GDP for at least two consecutive quarters, seems possible, perhaps even probable. 

Business profits in the near term will certainly suffer from reduced economic activity.  If global supply chains are realigned, longer-term business profitability could be adversely affected. Financial dislocations could occur, with some firms and industries in distress.  Whether or not these prospects are “in the market” remains to be determined.  It’s complex. Judgment on that question is more art than science.

Yesterday is the turf on which pundits and public figures play, often contesting “the last war”.  Especially because this is an election year, they will have their moment. But their currency is talk.  If we are fortunate, it will be just talk, not ill-conceived government policy.

The currency of the future, of the true drivers of this economy, is action. Business people, investors, and optimistic consumers will in time have their day, driven not by FUD, but by “animal spirits,” by the pursuit of profit, by enlightened self interest, by the hope of a improving outlook for the United States.

Warren Buffet, popularizing a notion articulated by Benjamin Graham (the famous investor and academic from the mid-Twentieth Century, of whom Buffet was a disciple), quipped that “[i]n the short run, the market is a voting machine, but in the long run, it is a weighing machine.”  Successful investors (as opposed to traders) engage in an arbitrage between the short term and the long term by seizing bargains offered in times of disfavor, whether general or company-specific.

Right now the market is “voting,” influenced by uncertainty and hysteria, and by the lessons of history.  Soon enough market participants will start “weighing,” assessing a new set of (lower) profit expectations, and comparing those to the (lower) stock prices that will have emerged in this decline.  At some point, enough investors will draw favorable conclusions from that comparison and will be driven to action.  One can be confident that many of them are already rolling up their sleeves and sharpening their pencils.

The decline in the stock market (as measured by the S&P 500 Index) since the top on February 19 exceeds 20%, a circumstance which by convention defines the end of the prior bull market.  The advance from the previous bear market low (March 9, 2009) saw the index rise from 676.53 to its peak of 3,386.15, an increase of 400.52%.

This second bull market of the 21st century lasted nearly eleven years, far longer than the 6.09-yr. average during the ten bull phases of the post- World War II era, and longer than any prior bull market during that period except the great boom which followed the war.

The annualized index performance in this long march was 15.83%, less than the 17.19% post-war average. But having run longer than a typical advance, the cumulative result during the teen years of the new century was exceeded only once before since the postwar boom.  

These bull market gains were a delight, but it’s likely that most of us didn’t take them to the bank.  Every bull market is followed by a bear phase, during which sizable and often sudden losses occur.  It remains to be determined how low the index will go in the current bear phase, and how long the decline will last.  The average post-war bear mauled the markets for 1.1 years (in a range from three months to 2.5 years), exacting a cost of nearly 35% (in a range of 20-57%).

The long-term index performance, including both ups and downs, offers a better indication of what investors might expect to achieve.  The entire postwar run, from the peak in May 1946 to the most recent top, saw the index rack up cumulative gains of 7.26% per annum.  The recent decline (through March 12) trimmed that result to 6.8%.  A regression trend line plotted through the peaks and troughs of the index performance confirms the realistic nature of this sort of expectation.  Investors who make long-term plans based on grander expectations are likely too optimistic.

Investors with long-term investing objectives should think twice about trying to time the markets, especially since the horse seems already to be out of the barn.  Timing successfully requires making two decisions correctly -- one to get out, another to get back in.  There is a high bar to success.

We know, based on postwar history, that the index has been in a bull phase more than 85% of the time, so the probabilities favor the “long” side. We also know that new bull markets typically launch recoveries with gains which are materially higher than the 17.5% achieved over the course of an average advance.  In the prior bull, beginning in March 2009, the S&P 500 Index gained more than 68% in the first year of recovery, and the performance in that period was skewed in favor of the early birds.

Another factor argues against any inclination to “trade” the market:  the volatility associated with stocks in recent years seems to have become more pronounced.  The media tend to talk about volatility as if it all occurs on the downside, but there is a better-than-symmetrical response on the upside.  A recovery can begin with a vengeance, in the midst of high volatility.  Market timers can be left flat-footed.

Increased volatility is a product of several factors, including the emergence of electronic markets, and the proliferation of news outlets which report and comment daily on economic and market events, as well as general news and information. The electronic age has collapsed the time it takes for people who are paying attention to make decisions.  If one is not paying close attention, one should probably make fewer decisions.

Another important influence contributing to volatility is the increased presence in the market of “technical” traders and arbitrageurs.  Such actors do not embrace the medium- to long-term horizon of typical investors, including institutional fund managers, but instead act to capture short-term price opportunities.  They are set up to do that, and have a trading cost structure and scale of operation which makes that a practical pursuit.  For most market participants that is not true.

This observation is not meant to disparage traders.  It’s a free country, and they stand ready to put their money at risk, with the objective of earning good returns.  Most of the time, their presence is beneficial to the rest of us.  The collapse of trading spreads is the best example of that.  It wasn’t that long ago that trading costs were quite high, with stocks quoted on 1/8th and ¼ dollar spreads.  These days our most liquid stocks are quoted with a one-cent spread between the bid and the offer.  The narrowing of that gap is in great part a result of the liquidity supplied by the trading community.  A price quoted on such a narrow spread reflects greatly improved liquidity, deep enough for most investors to operate without market impact.  That’s a good thing.  It reduces the cost to Main Street investors of participation in the stock market, whether directly or through managed products like mutual funds and ETFs.  But in the short run, some trading strategies can tend to exaggerate market moves.

The popular media often talk about “market volatility,” when in fact they mean market decline.  Talking heads on TV will cite the VIX as “the fear index,” with the implication that a high VIX portends rough times ahead.  Not so. The VIX is a measure of implied volatility derived in real time from the options markets, based on the premium over intrinsic value at which both puts and calls are trading.  Volatility is also manifest on the upside, and the VIX will reflect that when sharp advances occur.  Make no mistake, a high VIX today has zero predictive value about the market level in the future.  That much is clear in the data.

At the present moment, market participants are expressing fear, uncertainty, and doubt (FUD) about the price the latest coronavirus will exact from us.  The efficiency of and ease of access to the stock market gives us an easy and quick way to manifest our anxiety.

We should understand the sharp stock market decline as an acknowledgment that business fundamentals have changed for the worse, at least for a while. The “social distancing”, reduced travel, lost work days, and quarantining needed to inhibit the spread of the virus will likely impair economic activity in the current quarter and the next, perhaps longer.  A recession, understood as a decline in GDP for at least two consecutive quarters, seems possible, perhaps even probable. 

Business profits in the near term will certainly suffer from reduced economic activity.  If global supply chains are realigned, longer-term business profitability could be adversely affected. Financial dislocations could occur, with some firms and industries in distress.  Whether or not these prospects are “in the market” remains to be determined.  It’s complex. Judgment on that question is more art than science.

Yesterday is the turf on which pundits and public figures play, often contesting “the last war”.  Especially because this is an election year, they will have their moment. But their currency is talk.  If we are fortunate, it will be just talk, not ill-conceived government policy.

The currency of the future, of the true drivers of this economy, is action. Business people, investors, and optimistic consumers will in time have their day, driven not by FUD, but by “animal spirits,” by the pursuit of profit, by enlightened self interest, by the hope of a improving outlook for the United States.

Warren Buffet, popularizing a notion articulated by Benjamin Graham (the famous investor and academic from the mid-Twentieth Century, of whom Buffet was a disciple), quipped that “[i]n the short run, the market is a voting machine, but in the long run, it is a weighing machine.”  Successful investors (as opposed to traders) engage in an arbitrage between the short term and the long term by seizing bargains offered in times of disfavor, whether general or company-specific.

Right now the market is “voting,” influenced by uncertainty and hysteria, and by the lessons of history.  Soon enough market participants will start “weighing,” assessing a new set of (lower) profit expectations, and comparing those to the (lower) stock prices that will have emerged in this decline.  At some point, enough investors will draw favorable conclusions from that comparison and will be driven to action.  One can be confident that many of them are already rolling up their sleeves and sharpening their pencils.