Central banks and governments are throwing all they can at the coronavirus crisis. At the same time, the numbers are still deteriorating in many places, there’s a lot we don’t know about the virus, and the economic data is about to get even uglier.
This has all sent stockmarkets on a wild and disorientating rollercoaster ride, where terror of losing money is only matched by terror of missing out on the rally.
In my view, investors need to just stay calm, keep an eye on what they want to buy, and if it gets cheap enough, they should go ahead regardless of what the wider market is doing.
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But even the most sensible investor daydreams of calling the turn in a crash like this. So let’s go ahead and ask the question: have we seen the bottom yet?
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This isn’t the bottom
Do I think we’re at or near the bottom? No, probably not, is the short answer. To be clear, that doesn’t mean you shouldn’t buy anything right now. I feel that there are a lot of attractive assets out there and I believe that anyone who buys well just now will not regret it within a few years or maybe even less than that.
I also don’t see much point in trying to time the market. If you see something that looks good value and you have the capital available and the patience to sit on it for a while, then go ahead and buy it.
But if we’re looking at the narrow question of are there more falls to come or are we back in a bull market? – then I just don’t see it. There’s simply too much fear out there. The wild swings in the market are perhaps the best evidence of that.
Behavioural investing expert James Montier over at GMO points out that fear feeds on fear in financial markets during downturns. For much of the time, you can assume that markets are broadly rational. There are enough people who are trading with their sensible heads screwed on to keep prices in some sort of touch with reality.
But when panic kicks in, our survival reflexes take over. That short-circuits the sensible side. Investors don’t think about the fundamentals. Instead they think: “I lost money yesterday, I don’t want to lose money today.” You also get panicky attempts to call the bottom or recoup losses – hence the wild swings around during crashes.
(This also works for greed during bubbles, by the way. If you’re interested in market psychology, I wrote a lot more about all of this stuff in my book on contrarian investing, The Sceptical Investor.)
Charles Gave of Gavekal put out a note this morning that complements Montier’s nicely. Gave notes that, for the majority of the time (about 80%), the market ambles along the way that theory says it will, and diversification (across individual equities) works nicely.
But for about 20% of the time – during extreme panic or bullishness (ie, crashes and bubbles) – diversification basically stops working, because everything goes up or down in tandem as investors panic.
In effect, most of the time, the market is broadly guided by the fundamentals. But for that 20% of the time, it’s driven mostly by what the market itself has done recently and how badly burned investors are feeling as a result.
What gives us an idea of whether we are in “fundamental” or “self-fulfilling prophecy” territory? Gave notes that it’s volatility. When volatility is a lot higher than its average, “the market is no better than a game of craps”. You’ll see both violent crashes and equally violent rallies, but anyone who piles in should expect a very bumpy ride indeed.
For the moment, volatility remains elevated, and that’s probably the best indicator that we’re still in the panicky phase.
The moral hazard bubble
This points to a bigger, more fundamental problem that we’ve mentioned before here. The problem is that prior to this crash, the market was massively short volatility, probably more so than ever before. “Short volatility” is a jargon-y term which simply means that no one expected asset prices to go down.
This complacency is a factor in every bubble. But it’s been much more of a factor in recent years because investors have grown convinced that central banks would always be both willing and capable of bailing them out.
A belief that you’ll always be bailed out causes you to underestimate risk. And a desire to pursue yield in a low-yield world encourages the use of leverage (borrowed money) to turn bets on small, apparently predictable arbitrage opportunities into high-return opportunities.
These are sometimes known as carry trades. They’re also sometimes described as “picking up pennies in front of a steamroller” – they look like low-risk trades until the instant that they turn, and then you get squashed.
In fact, in the latest issue of MoneyWeek magazine, out tomorrow, economist and author Tim Lee explains how what we’re seeing right now is a “carry crash” – the point at which all of those trades have been forced to unwind. (Subscribe now and get your first six issues free).
In effect, we’ve had a “moral hazard” bubble. The US Federal Reserve and other global central banks are doing their best to keep that running, but they've come up against a situation – in the form of coronavirus – that central banks can’t actually tackle on their own.
So what’s the eventual outcome? Tim discusses three scenarios in his piece. Firstly, central banks and governments might manage to get the economy and markets to go back to the way they were, and so the moral hazard bubble continues.
Secondly, they might ignite rampant inflation, which would – to put it gently – change everything for investors. Thirdly, they might entirely fail to underpin the system, and we’d have a massive deflationary collapse.
So we’re looking at a return to the status quo; an inflationary panic; or a plunge into deflation. You might not think this all that helpful, as of course, each outcome has entirely different implications for your investments.
However, Tim does have a view on the most likely outcomes. Better yet, he also explains which market indicators will give us an early warning of which scenario is unfolding. So I’d heartily recommend reading his piece. And if you don’t already subscribe, then seriously – why wait? Right now you get your first six issues for a grand total of zero pence – just sign up now.
