Equities are trying to find a floor even though the news flow on the spread of the coronavirus outside of China hasn’t shown any signs of improvement. A number of market indicators would suggest forward returns from current oversold levels should be pretty good, but further declines in the near-term cannot be ruled out. In this environment, investors are best served by accepting and ignoring downside volatility, rather than taking it as a signal of inevitably worse outcomes pending.
It’s not just the coronavirus that caused the plunge in equity prices. Before the correction started, sentiment was overly optimistic and breadth had deteriorated. On February 21st we got the latest Markit Composite PMI reading which showed economic contraction – its worst reading in seven years. It was even more surprising to see the contraction coming from the service sector which had been a perpetual growth machine. And then there was Bernie’s surge in the polls. Many market participants and businesses are extremely wary of his democratic socialist platform. Yesterday’s strong showing for Joe Biden calmed the markets today and sparked a rally in health care stocks. Over at electionodds.com Biden now has a 75.5% chance of winning the nomination.
In our view, the main culprits for the market slide last week were hedge funds, some highly leveraged. At first, funds sell lesser quality holdings, but when things get tense they sell their high quality, liquid holdings leaving other investors with no place to hide. Hedge funds are/were preparing for a global recession, but hedge funds tend to shoot first and aim later. Computer algorithm trading certainly piled on and added to the volatility. It is our observation that individual investors were not aggressive sellers last week.
Ten year Treasury yields are at record lows thanks to both the pricing in of Fed easing and massive risk aversion. Tuesday’s Fed cut was the first one outside of its normal meeting schedule since October 2008. But lowering borrowing costs won’t solve the most immediate problem – supply chain disruption. The disruption of global supply chains is vastly different from a hit to aggregate demand, which is what monetary easing is supposed to address.
We don’t know how far the virus will spread or when it will be curbed. And market volatility isn’t likely to abate soon. But we know patient, long-term investors will win in the end. Panic-induced trading is not a successful strategy. We are diligently analyzing the investment landscape for new ideas; some good quality stocks are down 20% off their highs. And rebalancing is just as valuable after a market slide as it is on the upside when markets are hitting new highs. That is, for portfolios now below their target equity ratio, now is a good time to buy quality stocks at cheaper prices.