Keeping Calm During a Panic Selloff (FAQs)
What is causing the market volatility?
Following a remarkable rise in stock prices up until February 19, the rapid spread of a new coronavirus strain (Covid-19) suddenly threatened to disrupt the production of goods and services and to push the world into a recession. The governments of the countries most affected by the virus implemented draconian containment measures (border closures, quarantines, school closures, …). These steps, aimed at avoiding a collapse in the healthcare system, created panic among the public and will take a heavy toll on the economy.
On the heels of that shock, long-simmering tensions in the energy market (see below) came to a head, triggering a sudden, sharp drop in crude oil prices. Because of the energy sector’s prominence in the corporate debt market, investors began to worry that its financing difficulties could spill over to the market at large. Constraints on companies’ ability to fund their operations and growth would further dent GDP.
Governments and central banks around the world are preparing to take large steps to counter the economic fallout caused by the virus.
On March 12, the S&P500 index entered an official “bear-market,” defined as a drop of -20% from the peak. Along with a collapse in the price of oil, interest rates plunged to below 1% in the US. The VIX volatility index, commonly known as the “fear index,” is touching levels not seen since the 2008 financial crisis. The market drop feels extremely painful because of its speed and not its intensity. There are no precedents for the US market to move from an all time high to a bear market in 22 days. Historically the faster the moves the shallower are the maximum drawdown.
How bad can things get?
As long as the pandemic and panic continue, it is very hard to make a case for a market bottom. Every crisis is different and follows its own course. What is common to every crisis is that investors feel helpless and think the situation will only get worse. Typically, when investors “throw in the towel” the market finds its bottom and rebounds. It is useful to look at market drops in probabilistic terms, since we have many examples of bear markets.
In an average bear market, the peak-to-trough market decline is about –35%. The S&P500 index is now down –26.7% from the highs touched on February 19. Another –8.3% drop would make this a normal bear market. A very severe bear market/financial crisis could see drawdowns of -45% from the peak. Our assessment is that the US banking sector is healthy (thanks to the regulations imposed after the 2008 crisis) and it is not the epicenter of the problem. Unlike 1929 and 2008, this is not a classic housing - and banking - related financial crisis.
During a recession S&P500 corporate earnings typically contract about 10% to 15% compared to the previous year (before they recover). At their lows, markets may trade at price to earnings (P/E) multiples of 15x. Applying this rule of thumb to the S&P500, at the depths of a recession the index could be trading at a level of 2,200 or –12% below the current level (2,480).
Given the fact that interest rates are very low, gasoline prices are about to drop sharply, and monetary and fiscal stimulus is coming, we think that the US economy and markets are likely to rebound sharply once the pandemic passes. And it will pass!
What actions are you taking?
Our first line of defense has always been allocating assets prudently, based on the client’s risk profile and market valuations. Most of the risk management is implemented when we start an investment plan and not during a crisis. Our primary focus is and has been to make sure that the accounts are invested within suitable risk constraints for each client. We regularly monitor the portfolios to make sure they are properly allocated. At the end of this month, when you check your account balance, you will find that you did not lose as much as the market.
The crisis has been triggered by a highly unusual shock. We are closely monitoring and thoroughly reviewing the ability of the businesses we invested in to withstand this shock and to prosper after it eventually passes. Given the unprecedented origin of the crisis (a global pandemic) we need to re-evaluate the thesis behind several of our positions, especially the ones closely related to the travel, leisure, and hospitality sectors.
Throughout the years we have been putting a lot of emphasis on avoiding highly levered situations. We always thought that low interest rates provide perverse incentives for mediocre companies to borrow at low cost and misallocate capital. Therefore, our portfolio companies typically have low financial leverage ratios and should easily be able to navigate an adverse credit environment.
Our plan is to rebalance the portfolios and to add some new desirable positions as their valuations become more attractive during this indiscriminate and virulent market selloff. It is our belief, corroborated by extensive evidence, that aggressive short-term tactical changes to the portfolios to minimize the impact of volatility will be more damaging than helpful over time.
Why did oil drop so much and what are the ramifications of such a move?
Growth in U.S. shale oil production has contributed to a chronic, global oversupply of crude oil. Today the US is one of the world’s largest oil and gas producers. After a sharp price drop in 2014-2015, the other two largest oil-producing countries, Saudi Arabia and Russia, attempted to prop up prices by agreeing to limit their production, but the negotiations to renew the production quotas failed on the weekend of March 7. Prices immediately plunged -30% in anticipation of a supply glut.
Note that the breakeven price is higher for shale production in the U.S. than for conventional extraction elsewhere. Observers suspect that the Saudis and Russians hope to undercut the US producers’ growing market share (and influence) by driving some U.S. shale oil companies out of business.
Low oil prices are a boon for US consumers, equivalent to a large tax cut. However, oil and gas capital expenditures have become an important part of the US economy. A dramatic oil price drop will have adverse consequences for the fixed investment component of US GDP as well as creating credit strains. The collapse in oil prices will also have unforecastable geopolitical ramifications for several exporting countries.
Why are US Treasury yields at historical lows and what does that mean to me?
Several factors are contributing to record-low Treasury yields. On March 9, the US 10-year Treasury bond yield dipped below 0.5% for the first time in history. The recent plunge in stock prices has driven investors to the safety of U.S. government obligations, which are both free of default risk and highly liquid. That increase in demand has pushed Treasury prices up and yields down.
Demand for U.S. Treasuries derived further strength from income-seekers in countries where central bank policies have produced negative interest rates. The Fed has not been equally aggressive, but by lowering short-term interest rates in hopes of sustaining the U.S. economic expansion, it has pushed investors into longer-dated Treasury bonds in order to capture higher yields.
Low interest rates are very supportive for financial and real assets. Once the panic subsides, investors who hope to generate satisfactory returns will find no alternatives to going back to stocks and real estate.
Will I still be able to retire as planned despite the market drop?
Market declines like the recent one can be unnerving. Similar-percentage declines of the past show up as just minor dips in the long-run growth of wealth invested in the equity market. The only way to suffer permanent damage from these events is to exit the market at the low point and miss the subsequent recovery.
Securing a comfortable retirement requires two actions: (1) Devise a sound plan. (2) Stick to that plan. Successfully executing a sound financial plan isn’t predicated on beating the market to the punch on every rally and correction. That’s fortunate, because nobody consistently manages to time the market over an extended period. The key is rather to have the emotional strength to stay focused on your ultimate objective of maximizing the wealth you will accumulate by the time your savings become your main source of income.
For those investors who get anxious and check daily their account balances, we strongly recommend taking a step back. Watching the large market fluctuations too closely is likely to lead you to decisions that you will regret later on.
What steps are you taking for your business to prepare for the pandemic?
Long before the COVID-19 virus struck, we had a business continuity plan in place and we regularly test/update it. It has been proven that (voluntary) “social-distancing” at the early onset of an epidemic can have a dramatic impact on containing the contagion rate and protecting the most vulnerable individuals. We therefore decided to temporarily activate our remote work-from-home contingency plan. Our business runs normally without disruptions with our team working from home. Our technological architecture allows our team to effectively collaborate remotely and to carry out all functions on a timely basis from our home offices.