The Coronavirus Head Fake

“If you are ready to give up everything else – to study the whole history and background of the market and all the principal companies whose stocks are on the board as carefully as a medical student studies anatomy – if you can do all that, and, in addition, you have the cool nerves of a great gambler, the sixth sense of a kind of clairvoyant, and the courage of a lion, you have a ghost of a chance.”¹

                                                                                                   Bernard Mannes Baruch

                                                                                                                      1870 - 1965 

Ever since the coronavirus hit our shores, volatility has gripped Wall Street.  Even disciplined investors abandoned carefully orchestrated equity strategies as share prices tanked.²  According to data from Fidelity Investments, as reported by LPL, roughly 18% of investors liquidated their equity holdings during the February-May period, including a full third of investors over the age of 65.³  There are reasons to believe it was a head fake.

In the face of a full-blown pandemic, massive economic dislocations, and social unrest, share prices rebounded to near pre-virus levels, with the technology-laden NASDAQ closing up 12.7% through the end of June. Other major indices did not fare quite as well in the first half of the year with the S&P 500 and the DJIA still down 4% and 8.4%, respectively (Figure 1). Was it a fluke?  Perhaps.  But it was also consistent with historical norm.

Prudent investors never chase returns without understanding the risks involved.  And just as there are numerous statistics for measuring investment returns, there are lots of ways to describe risk.  There are the odds of losing principal (i.e., “absolute risk”) - which we view to be highly destructive to portfolios and the most worth avoiding—or the chance of underperforming a benchmark (“relative risk”).  Then there is volatility.  Often framed as a risk in financial markets, volatility can and frequently does cut both ways.  While many investors turn volatility into capital destruction by acting imprudently and selling stocks when they should be holding or buying, volatility can also grant more patient investors lucrative opportunities to capitalize on such dislocations and buy stocks at a discount to intrinsic value.  In truth, some of the strongest portfolios are built with the implicit assumption that volatility will inevitably occur but can be successfully managed when it does.  Still, it can be difficult to maintain a steady hand in the face of “extreme” volatility, especially as of late, so let’s take a more in-depth look at today’s topsy-turvy market from this angle.

On casual examination, volatility does present itself as a concern.  Measured from the turn of the century, the S&P’s monthly returns have averaged 0.4% (blue line in Figure 2), albeit a bumpy ride.  As shown below, some 40% of the returns finished in the red.  Of these, four were particularly disconcerting, double-digit declines.  Was the Covid correction (March 2020, -12.5%) the worst?  Hardly.  On this score, the 2007-09 Great Recession produced the blue-ribbon champ.⁴

The annual picture is equally discomforting (Figure 3).  Imagine the investor who allocated 100% of their portfolio to the S&P 500 at the end of 1999; the first 3 years of returns were awash in red ink. Should 2020 end on a sour note, such a portfolio will have lost money in 7 of the last 21 years. 

 Investors instinctively realize that there is no such thing as a “free lunch.”  They know that downturns happen with regularity and are of various magnitudes.   The challenge is to maintain an even keel.  The reality is that, on average, the S&P has appreciated 5.6% per year since 1999 (Figure 4), with two-thirds of the returns between -12.0% and +23.2%.  This also means, however painful and rare, outsized month-over-month declines of 12.5% like we experienced in March are inevitable.

Sure, there have been sleepless nights aplenty since the coronavirus outbreak.  Doubtless more will follow.  But stay disciplined, though there can be no guarantees, the odds favor a positive outcome over the balance of 2020 (Figure 5).  Keeping these historical trends in mind, now’s the time to review asset allocations and stress test equity holdings.

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