Welcome To Financial And Economic Re-education Camp

For the casual observer, the stock market’s rapid slide looks like madness. It was, after all, only last week that the S&P 500 closed at a record high. Six trading days later, the market has lost 12% (as of Feb. 27)–the fastest correction on record for declines of 10%-plus. But before we let recency bias take complete control of our minds, let’s consider if there’s a method in Mr. Market’s madness.

At its core, the sharp decline in stock prices is an effort to reprice a future that must deal with the coronavirus (Covid-19) on the world stage. It now appears that containing the virus is impossible. The World Health Organization says the Covid-19 outbreak has reached a “decisive point” and has “pandemic potential.” The outlook as recently as a week ago, when the S&P traded at a record high, is ancient history.

The operative question for the market’s sharp refocus is neatly summed up the famous line attributed to John Maynard Keynes: “When the facts change, I change my mind. What do you do, sir?”

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Mr. Market emphatically chooses the latter, as he always does. In the short run, discounting the future can be a messy business, as recent days remind. More of the same is likely coming. The basic issue here is that a Covid-19-laced future is considerably more uncertain compared with the pre-coronavirus outlook. The transition is all the tougher because the US stock market had, for weeks, effectively ignored coronavirus risk, preferring instead to price in smooth economic sailing and discounting an unusually sunny future. And then suddenly, Mr. Market thought otherwise and the results are ugly as sentiment tries to play catch-up with world events.

It’s not unlike a traveler who was expecting a mild, spring day and instead finds himself in the middle of a hurricane. Shifting to reality is destined to be challenging in the best of circumstances and is made all the worse because he’s dressed for beach weather. Result: attitude adjustment on steroids, in record time.

The market, in short, is being forced to discount a future with little if any context in modern times. It’s reasonable to assume that Covid-19 will continue to spread. Meanwhile, a vaccine is probably months away. Uncertainty has spiked and so the market demands a bigger discounting factor – a bigger margin of comfort until there’s more confidence for understanding what’s unfolding.

No one’s certain how this will play out and so the market is prudently erring on the side of caution. But this is hardly the first time that the crowd has been faced an impossible task of pricing in a future with new and materially bigger risks with unclear outcomes.

From an investor’s perspective, it’s all deeply unsettling, of course. As painful as a correction is, it’s helpful to keep in mind that we’ve been here before from a pricing perspective. The current 12% drawdown for S&P (as of Feb. 2) is, for now, a middling peak-to-trough decline vs. the market history since 1960.

There’s probably more market discounting to come, however. Until the world develops a degree of clarity on understanding and managing Covid-19 risk, Mr. Market will likely demand a bigger discounting factor. Meantime, history suggests that the S&P 500’s drawdown could sink further into the red, substantially so, and still not dispense anything that’s unusual.

Even before the coronavirus crisis it was obvious that the S&P was pricing in a future of bliss. The trailing 10-year return, which cuts out a fair amount of the short-term noise that inhabits the 1-year trailing change, has been reflecting optimism in a fairly aggressive degree. In January, the S&P posted an 11%-plus annualized performance over the past 10 years—that’s roughly at the 75th percentile since 1964.

Recent results were near the best on record for the past decade. But market history never whitewashed the downside possibilities. A 10-year return has, at times, been flat or even modestly negative. That leaves plenty of room for discounting in the days and weeks ahead when you consider that the current 10-year performance (as of Feb. 27) was still above 10%. That strong performance was surely destined for lesser realms even before coronavirus reordered expectations. Now, in the current environment, it’s a virtual certainty.

So, what’s the market’s 10-year-plus expected return now? Answering is a work in progress. Mr. Market is clueless at the moment, as is everyone else, for the simple reason that the world is struggling to understand Covid-19 and its impact on the global economy. For the moment, everyone’s guessing and so the market will struggle to price in an unusually uncertain future.

Yes, it could get ugly. But that’s nothing new. Fortunately, stocks aren’t the only game in town. But in the current climate, reducing expected returns could deliver dramatic haircuts. And while a portfolio holding multiple asset classes offers useful risk management properties, it’s not a silver bullet. Consider Vanguard STAR (VGSTX), a multi-asset class fund with an impressive track record — 8.6% annualized over the past 10 years, for example. But several 10%-to-20% drawdowns for VGSTX have occurred since 1985–and in the 2008 financial crisis the fund’s peak-to-trough decline was 37%.

No one’s really safe in a hurricane and so it’s prudent to manage expectations realistically. If you own VGSTX, for instance, you should have been prepared for a 37% drawdown.

So, what awaits? Perhaps a long struggle to reacquaint ourselves with a risky world–risk as it always was, not as it was perceived to be via the view of the last several years to the exclusion of the long sweep of history.

Welcome to the financial and economic re-education camp, and the first lesson is attitude adjustment. In case you missed it, we just experienced regime shift, says Ned Rumpeltin, the European head of currency strategy at Toronto-Dominion Bank. “The complacency that had defined the market’s behavior over the last few weeks is gone, that is for sure.”

For once, we have a market observation that suffers no debate.

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By James Picerno

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