From an email sent on March 19, 2020:
Good evening, IIM investors.
This week we appear to be witnessing the worst psychological – though not statistical – impact of COVID-19.
While we are currently waiting on the details of the fiscal stimulus program that will help combat the economic effects of the coronavirus, the monetary stimulus has arrived.
Earlier this week, the Federal Reserve cut the federal funds rate to zero, announced a program to buy $700 billion in Treasury and mortgage-backed securities (i.e. quantitative easing or “QE”), and activated dollar swap lines with five other central banks (to provide liquidity). This occurred during an emergency session just days before the Fed’s next scheduled meeting and came on the heels of the Administration declaring a national emergency in response to the coronavirus. Although investors widely anticipated a Fed rate cut to zero, the immediate global market reaction was negative.
In these historic times, it’s important for us long-term investors to keep our perspective and clarity. Maintaining perspective is no assurance that markets always go up – or bounce back immediately. It also doesn’t mean that there aren’t serious issues affecting public health or the economy. Nor does it guarantee that the financial journey will be easy.
Instead, just like having the right perspective on a problem can help to solve it, having perspective in investing is about addressing the right issues…while knowing what we can and cannot control. At the public health level, we cannot control the nature of the coronavirus or change how far it has already spread. At the economic level, we cannot change the fact that growth will slow for several months or even quarters, nor can we directly control the response of governments and central banks. At the market level, we cannot change the fact that there is significant uncertainty…and that volatility of late has been historic.
What we can do is react to each of these appropriately. We can heed the advice of public health experts. We can keep a close eye on the economic data to assess whether this is a transitory event or whether there are structural implications. And, most importantly, we can maintain discipline in our investments by staying diversified, maintaining a long time horizon, and not overreacting.
Given recent events, it’s natural to draw parallels to past crises. At the moment, there are two primary reasons that some pundits are drawing comparisons of late to the 2008 financial crisis.
The more superficial reason is simply that markets have fallen into bear market territory with large swings, both positive and negative, on any given day. Last year, the average daily move in either direction was about half of a percent for the S&P 500. This year, the average swing is almost 2%. 12 trading days have been above plus or minus 3%, 9 days above 4%, and two days larger than 9%. Not only are these swings larger than investors have experienced in twelve years, they are some of the largest since the Great Depression.
The second and more substantive reason for investors to draw comparisons to 2008 is the fear of financial contagion. While this is still not the most likely outcome, there are scenarios in which short-term liquidity problems can cascade into long-term solvency ones. For instance, it’s one thing for an individual to go without a paycheck for a couple weeks because their small business is closed. It’s quite another if this spans months and the individual faces a cash crunch.
Multiply this problem across the economy and scale it up for large companies who rely on bond markets for funding, and it can become a serious problem. Credit spreads have spiked in recent weeks and bond market volatility has risen significantly as well. The MOVE index, essentially the bond market’s counterpart to the VIX, has risen to its highest levels since the global financial crisis.
However, the federal government and the Federal Reserve understand this and, as per the above, both are on it. Economic stimulus and liquidity provisions have been implemented in recent days, alongside public health measures. These go hand-in-hand, since one of the main side effects of slowing the virus is an economic slowdown. So a key difference now versus 2008 is that the Federal Reserve and Uncle Sam both have playbooks that were developed during the last crisis – and are being implemented quickly.
For long-term investors, it continues to be important to maintain perspective and focus on what we can control. Although markets are in bear market territory and daily swings have increased, the broadest perspective one can have is to understand that markets behave in cycles – both in terms of prices and investor psychology. The history of the market is filled with manias, panics and crashes which, viewed in hindsight, could have been handled better by investors. While each episode may have its own unique circumstances, the fact remains that staying disciplined and not overreacting to backward-looking market moves is the best way to achieve long-term financial goals.
Below are a few charts that help to put recent government stimulus actions in perspective.
The Fed made an emergency rate cut to the zero lower bound just days before its next scheduled meeting. This is the first time rates have been at zero since 2015, and is the largest cut since the 2008 financial crisis. The Fed will release new economic projects at its next meeting which should reflect its latest decision.
In addition, the Fed also announced $700 billion in asset purchases, a resumption of the post-crisis quantitative easing program, in addition to dollar swap lines with other central banks. This is to prevent a short-term crisis from harming the plumbing of the financial system.
Bond yields have jumped in recent weeks in response to the coronavirus, although this should be put in perspective relative to the 2008 financial crisis and the 2014-2016 oil price collapse. Still, volatility in the bond market has also spiked to its highest level since the 2008 financial crisis. While the plumbing of the financial system still appears to be orderly, the Fed’s emergency actions along with the government’s public health and fiscal stimulus are an attempt to preempt problems down the line.
While investors can’t directly control government actions or the spread of the coronavirus, they can maintain the right perspective and focus on what they can control: staying disciplined and maintaining appropriate portfolios. The chart above shows that markets have pulled back at many points across history – sometimes for extended periods. However, those with the right perspective and patience are better able to achieve their financial goals.
Investors should focus on what they can control: their own behavior. While there is much about the coronavirus that remains fluid and uncertain, investors who stay disciplined are much more likely to ride out the storm successfully.
Please let Retz or I know if you have any questions. And stay safe out there.
Islamorada Investment Management