The coronavirus crisis has revealed consumer behaviour at its most extreme, as shortage fears have resulted in people stockpiling toilet paper and food. But among investors, we see the opposite to hoarding. There has been widespread dumping of risk assets and a flight to quality in assets like gold and government bonds, followed by periods of sharp market rises.
Nonetheless, the contagion effect is similar. Images of bare supermarket shelves stoke more panic buying among consumers, while steep declines in market indices and the spectre of circuit breakers being triggered – which happened several times in March – spark further selling.
Many commentators have been quick to call consumer hoarding irrational: if warehouses are stocked and supply chains are operating smoothly (for now) then shelves can be replenished and there should be no reason to hoard. Of course, consumers may know something that policy makers do not. And perhaps, automatically deeming this behaviour irrational is itself a form of bias.
Can we suppose that investor behaviour is similarly irrational? In this piece, we consider:
- Whether investors are actually behaving rationally in response to an unprecedented event;
- What we can we make of the sporadic market bounces over the past week; and
- Why investors should confront their biases, take an active, analytical approach and consider if resisting the temptation to withdraw from the market could be worthwhile.
Pricing in a worst-case scenario (once we know what it is)
Our colleagues in Pittsburgh argue that markets are plumbing for a bottom. But this is an ongoing process and will not happen over a single day. It is clear that markets may vacillate as they try to price in the worst-case scenario, something that is difficult to determine when the environment is rife with uncertainty. Much is unknown regarding the spread of the virus and how successful the efforts will be to mitigate its effect on health services.
Plunging equity values and corporate income have turned the focus to company debt and default risk, meaning that liquidity within fixed-income markets has been extremely challenged. Oil prices have collapsed, depressed by both supply and demand pressures, while entire sectors like airlines, hospitality and consumer staples have been decimated.
Figure 1 shows how dispersion has fallen between the returns of different sectors – something that tends to decrease during periods of market stress, such as in 2016. Because the current sell-off has been more visceral than the global financial crisis – affecting the local coffee shop, pub and playground – it may trigger more survivor-type behaviour.
Figure 1. Dispersion between sectors has shrunk
Source: Federated Hermes, as at March 2020.
The speed of the equity market sell-off – the S&P 500 recorded its fastest fall into a bear market on record – indicates how fragile the global financial system is. While the concerted efforts by central banks have been unprecedented, they may merely plug a large revenue gap rather than provide any real stimulus.
Last week saw the release of the worst US jobs data in history, after 3.3m people claimed unemployment benefit. Nonetheless, markets rose after the bipartisan passage of the $2trn US economic stimulus package. With this level of uncertainty – and the known preference of investors to avoid loss (and to focus more on the pain felt by losses than the joy felt by gains) – it is perhaps rational to wish to withdraw from markets. But if this is the case, what can explain the intermittent bursts of market strength?
One reason could be the record amount of cash in money-market funds (see figure 3). This suggests that investors have kept some reserves on hand. In the aftermath of mass liquidations, it is natural to assume that they will now be looking to pick up some bargains.
Figure 3. Dry powder: waiting for deployment
Source: Federated Hermes, Investment Company Institute, Bloomberg, as at March 2020.
Banning shorts: a counterproductive move?
To what extent is short selling and short covering (or the process of buying back borrowed securities to close an open short position) behind the sharp market moves? Not much, it seems. In the US, short selling only made up a small proportion of total trading before the market turmoil – although some short covers over the past week may have been behind the sharp market rises (see figure 4).
Figure 4. The sell-off was accompanied by a spike in short interest
Source: Dow Jones, Federated Hermes, as at March 2020.
Six European countries have imposed short-selling bans in recent weeks. It seems this did little to stem losses, especially as short selling does not appear to be the cause of the initial falls. While these bans attempt to stem further downward pressure caused by short selling, they send a message about market fragility that can further undermine confidence.
It seems that the markets with bans in place – France, Belgium, Austria, Greece, Spain and Italy – have been weak even with the restrictions. While the indices have stabilised somewhat since the ban, this may also be markets naturally finding a bottom. Figure 5 shows that performance has more or less tracked US markets (where there was no ban).
Figure 5. Have short-selling bans boosted market performance?
Source: Federated Hermes, Bloomberg, as at March 2020.
Technicals: time to shine
The current market has seen fundamentals swept aside in a wave of indiscriminate selling. For some investors, this has elevated the importance of technical analysis, which provides an insight into the level of investor fear. The VIX is a commonly used indicator of this and we can also refer to BBB-rated credit spreads, gold and the US dollar as gauges of confidence.
Volume-adjusted price movements, the standard deviation of moves relative to the moving average and ordinary charting can also inform investor psychology when fundamentals give a less clear picture. Some investors may be examining charts and other technical indicators to time their buying activity.
There has been considerable focus on the likely shape of the recovery: will it be V-shaped, indicating a short, sharp rebound or more of a ‘U’, where the process takes longer to play out? Commentators have attempted to extrapolate a likely outcome by looking at the 1929 and 1987 market crashes, which can also inform expectations about the likely staying power of a bounce back. As figure 6 shows, we are only at the initial stages of making this comparison.
Figure 6. A long way to go
Source: Bloomberg, as at March 2020.
Volatility has eased off somewhat over the past week (see figure 7). This could be due to market fatigue or ebbing uncertainty as the new reality becomes normalised and worst-case scenarios priced in. According to strategists who are tracking how responsive market risk is to reports of new coronavirus cases, the elasticity of volatility tends to subside in response to virus news. Or perhaps, the combination of the increased gravity of the virus and the “no limits” commitment of authorities to mitigating the economic effect is having a neutral psychological impact.
Figure 7. Volatility has subsided in recent days
Source: Bloomberg, as at March 2020.
Rocket fuel: markets were supercharged before the crisis
Another reason for the sharp initial swings could be the substantial increase in options in use before the crisis (see figure 8). In February, investors used more options either to hedge their portfolios or gain convexity.
Figure 8. The volume of options in use soars
Source: CBOE, as at March 2020.
Generally, investors purchased out-of-the money options to hedge against unexpected market moves (this is when the underlying asset’s price is below the strike price). However, as the market fell sharply many of these options became at-the-money (ATM) options – in other words, the ones with the highest gamma (meaning the price of the option is the most reactive to changes in the price of the underlying asset).
Whether investors chose to hold onto ATM options or needed to buy them to quickly de-risk their portfolios, the price of options relative to their strike price indicated that investor demand for ATM options was higher than usual – something that resulted in a supercharged market.
The higher the volume of options outstanding, the higher the amount of delta hedging required by the option seller. In other words, whatever direction the market takes on any given day, its movements are likely to be elevated by the delta hedging of options sellers.
This heightened short-term momentum is in part responsible for the magnitude of the daily swings we have seen. In the aftermath of steep market falls, the price of options – like any insurance after an event – has increased sharply, which should mute their amplifying effect going forward.
Looking beyond the noise
The market correction has probably occurred at too rapid a pace for most long-term institutional investors to react in time. It is also likely that most of the initial selling has come from retail investors, hedge funds, risk-parity funds and other systematic strategies. Liquidations by leveraged exchange-traded funds cause a compounded downward effect, as unwinding the leverage makes them forced sellers in a market that is already falling.
Institutional investors like pension funds may find that their long overdue equity rebalancing has in effect been done for them. Diversified portfolios will face a true test if so-called diversifiers like real estate, private credit and private equity also show steep losses (albeit with a lag).
Long-term institutional investors are unlikely to look to sell at this time of weakness unless there is a pressing need for cash, while any investors who have learned lessons from 2008 will have a better match of assets and liabilities and access to liquid cash-substitutes to meet short-term needs.
It is worth bearing in mind that stepping away from the market at the wrong time can be extremely costly. If you remove the top 34 monthly returns of the S&P 500 from 1926 until December 2019, the overall annualised return falls from 9.4% to 4.5%. Crucially, most of these outsized returns followed periods of negative ones (see figure 9).
Figure 9. Exit the market at your peril
Source: Federated Hermes using Bloomberg data, as at March 2020.
As we navigate these unprecedented times, there has been a siren call to employ ‘mindfulness’ as a tool to build resilience and resolve. For our investment teams, frequent video calls, daily cross-team market updates and idea exchanges all help to ensure resilience and a sense of being connected against a backdrop of extraordinary trading conditions.
At times, we believe that it can helpful for investors to step back from the daily market noise in order to be mindful of what is really motivating sellers and buyers in the market – and to check their own biases and irrational behaviour. Be careful out there.