by: RGT Investment Management Team

“Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.” U.S. Secretary of Defense Donald Rumsfeld, February 12, 2002.

 

We began the year 126 months into the longest economic expansion in U.S. history. On February 19, 2020 the S&P 500 closed at an all-time high of 3,386.15 (as a point of comparison, the S&P 500 reached its nadir following the Great Financial Crisis on March 9, 2009 at a closing level of 676.53). Most market concerns at the beginning of 2020 centered around volatility due to contentious U.S. elections, continued tensions around trade, somewhat stretched valuations for financial assets, and the simple fact that the expansion, and the bull market, were getting somewhat long in the tooth.

 

Typically, though, it’s not the things that the market worries about, the “known unknowns,” that bring about violent downturns in financial markets. A great example of a “known unknown” is the Y2K crisis. We were warned about Y2K years in advance. It received large amounts of media attention, but because it was known and years had been spent addressing the problem the impact of Y2K was negligible. Instead it’s the event that no one sees coming, the “unknown unknown,” that is potentially the most problematic for markets. The Coronavirus, now known as COVID-19, is a perfect example of the kind of shock that the “unknown unknown” can have on markets.

When an “unknown unknown” shock occurs markets often react in dramatic fashion. That’s because markets are forward-looking, and they now must add a variable that they had heretofore not considered. But beyond that, the simplest explanation is that most humans fear the unknown. And fear has a way of creating quick and extreme reactions, which often turn into overreactions.

 

Financial markets are a perfect environment in which to see this sort of human behavior on display.

 

• Since the market close last Friday, February 21, the S&P 500 has dropped 11.4% through the close of trading on Friday, February 28. Foreign stocks, as represented by the MSCI-EAFE fell 6.7% over that same time frame.
• The last week has been the worst week in the U.S. stock market since the 2008 Financial Crisis.
• The 10-year Treasury is at all-time lows dropping from 1.46% on Friday, February 21 to 1.17% on Friday, February 28.
• Oil prices have fallen over $8/Bbl, or more than 15%, in a week’s time.

 

The last week has been a prime example of a reaction driven by the fear of the unknown. Let us stress as strongly as possible, almost everything about COVID-19 and its ultimate impact on financial markets is unknown. Another point worth noting is that reacting to unknown threats is not illogical. In fact, it’s an important human survival trait. However, it is not necessarily the best way to respond in your investment portfolio.

 

If indeed COVID-19 turns into a pandemic, it will not be the first pandemic of this sort with which markets have had to deal. The 2009 Swine Flu Pandemic (H1N1/09), which lasted from early 2009 to 2010, is the most recent example. Somewhere between 10 million to 200 million people are estimated to have contracted H1N1/09[i]. The exact number of deaths are not known, though one estimate puts the estimated number of deaths worldwide at somewhere between 105,700-395,600[ii].

 

Negative views make for great media fodder and feed into the market sell-off frenzy. But the latest news out of China, which has been the nation hardest hit by COVID-19, is beginning to seem more positive. While there will no doubt be an adverse impact on Chinese demand and output, it appears that the containment efforts by the Chinese government are starting to make an impact on the rate of transmission of the disease, which should be encouraging. Nonetheless, there is no visibility into the duration of the health crisis or to what extent this disease will ultimately spread.

 

What can we learn from history?

 

• These types of events are transitory. The key question becomes how the event lasts.
• Currently investors view the risks as to the downside, thus the violent sell-off of stocks and other “risky” assets and the rise in prices for U.S. Treasuries and other safe-haven assets. And as often happens, once markets begin to sell-off, pressure for other investors to sell rises.
• The long-term risks faced by investors are more about how the economy (and thus revenues and earnings) is impacted and for how long. If this follows the most recent global pandemics, then the economic impact should be temporary and it’s possible that markets rebound nearly as fast as they sold off.

 

Key Takeaways for Investors

 

• Right now, there is no visibility into the length of the health crisis. Thus, attempting to make a call on how this plays out from an economic and market perspective would be futile. Assuming the worst outcome is no more helpful than assuming the best outcome.
• Asset allocation is showing itself to be valuable during the latest market sell-off. Make sure your investment plan and asset allocation fit your circumstances. Well diversified portfolios are designed to lessen the impact of stock market losses, not to eliminate them entirely. The key is to be able to help mitigate your losses thereby easing your compulsion to feel the need to sell at market lows. If you can do this, you should you be better position to participate when markets recover.
• Cash for defense is just that, cash. But right now, you earn very little on cash. So, if you feel the need to get defensive in this way, you can’t concern yourself with return.
• Rebalancing and tax loss selling opportunities may present themselves. If you have a long-term outlook you should avail yourself of these opportunities, without an emphasis on trying to have perfect timing.
• Remember, you own stocks for a multi-year time horizon, not for what happens in a week, a month, or even a year. If you have cash to invest, market corrections like this can provide an opportunity to put it to work at lower valuations, thus potentially enhancing prospective long-term returns.

 

If you have any questions or concerns about these matters and how they impact your portfolio and your financial situation, please contact your RGT advisor.

 

[i] “Report of the Review Committee on the Functioning of the International Health Regulations (2005) in relation to Pandemic (H1N1) 2009” (PDF). 5 May 2011. Archived (PDF) from the original on 14 May 2015. Retrieved 1 March 2015.

[ii] Dawood FS, Iuliano AD, Reed C, et al. (September 2012). “Estimated global mortality associated with the first 12 months of 2009 pandemic influenza A H1N1 virus circulation: a modelling study”. The Lancet. Infectious Diseases. 12 (9): 687–95. doi:10.1016/S1473-3099(12)70121-4. PMID 22738893.