Financial markets appear to have rallied to a certain extent following their dramatic drop last week on the frightening headlines surrounding the Wuhan coronavirus. But the scare provides a lesson for investors on what they should and should not do in the case of market shocks.
In November last year, I wrote a column with the tongue-in-cheek title “The secret to stock-market riches”. While I didn’t - and couldn’t - provide a formula for getting rich overnight, I did report on a presentation by Daniel Needham, the chief investment officer of Morningstar Investment Management, on the workings of financial markets.
The gist was that while markets are rational most of the time, in that asset prices generally reflect the fair value of those assets based on publicly available information, they are sometimes irrational. This is usually when emotions - fear or greed - override rational, independent decision-making, resulting in highly correlated buying or selling behaviour. Visualise a herd of wildebeest grazing on the savannah, each animal wandering around independently searching for tasty tufts of grass. Something triggers panic in the herd, and the animals collectively stampede off in one direction in a cloud of dust.
Needham said it was such irrational market episodes that presented opportunities for savvy investors - not as a way to instant riches, but as a way to beat the market over time.
It appears that the coronavirus outbreak triggered this type of correlated market response, although some market commentators suggest the move may not have been entirely irrational: investors may have used the scare as an excuse to sell off over-priced stocks.
In two podcasts on the coronavirus, Peter Brooke, a fund manager at Old Mutual Investment Group, said the effect on financial markets had been marked, with an 8% drop in the Chinese market.
He said Asian markets had been particularly affected, particularly in sectors such as tourism.
Interestingly, South Africa was among the biggest losers: the FTSE/JSE All Share Index dropped 5.5%, from 59001 points on January 17 to 55748 on January 28, since recovering, to 57528, at the time of writing.
Brooke said catastrophic events - this year we have also had the terrible fires in Australia and the volcanic eruption in the Philippines - often have a relatively small, localised impact on markets. He believes the coronavirus had a much bigger impact because jittery traders and fund managers may have seen this as an opportunity to reduce exposure to assets that had appreciated too much in the recent global equities rally.
Catalyst for a correction
Peter Geikie-Cobb, director and fund manager at MitonOptimal, also believes the virus scare was a catalyst for a correction. In a blog, he says: “The fundamentals have not changed. Monetary policy remains very loose and fiscal balance sheets are likely to support the global economy further. While not particularly cheap, equity markets are fairly priced. The ever-decreasing stock of publicly traded equity means that any technical sell-off, like the one we are experiencing now, should be taken advantage of.”
Like Brooke, Geikie-Cobb saw the market dip as a buying opportunity.
In a newsletter article “Counting the cost of catastrophe”, investment strategists Izak Odendaal and Dave Mohr of Old Mutual Wealth say the outbreak of the virus was an unexpected shock to the Chinese economy, but offer clear-headed perspective.
They say known risks, such as a likely Moody’s downgrade for South Africa, tend to be reflected in market prices - in investors’ parlance such risks are “priced in”. It is when unknown risks materialise that market mayhem ensues.
“In modern investing history, there have been only a few external events that have wiped investors out. Investors were more likely to face ruin from government policies (such as those that lead to hyperinflation) than from war, diseases or natural disasters,” they say.
“The 9/11 attacks, the biggest geopolitical shock of the past 30 years, caused a short-lived wobble on financial markets. Getting sucked into the dotcom bubble a few years earlier would have had a far worse portfolio impact. And, of course, subprime American home loans nearly caused a collapse of global capitalism eight years later.”
The biggest killer, say Odendaal and Mohr, is investor behaviour: buying high and selling low, reckless borrowing and excessive optimism.
They say that, over the longer term, equity prices move to reflect company earnings, property prices reflect rental growth and bonds respond to the inflation outlook. “It is these real variables that we should pay most attention to, not the events that grab headlines. Until such time as there is clarity on how the headline-grabbing events will impact those real variables, portfolio tinkering is unwise. Rather, portfolios should be appropriately diversified at the outset. History also shows that most of these events have a short-lived impact on markets, and the best approach is to be patient and sit tight.”
The team at Morningstar Investment Management is also sitting tight. In an article “Coronavirus: an investment perspective”, they reflect on epidemics such as Severe Acute Respiratory Syndrome in 2003, H1N1 (“swine flu”) in 2009 and the more recent Ebola outbreaks in Africa, concluding that while investors tend to react to epidemics, such short-term reactions don’t affect the long-term picture.
“With lives at stake, it would be uncaring to call the coronavirus ‘noise’,” say the Morningstar team. “Yet, if we focus on the investor’s perspective, we believe it is not time to act We certainly won’t be hitting the panic button, and we hope you won’t either.”