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The Bear Necessities

by Robert White, CFA

“There are decades where nothing happens; and there are weeks where decades happen”. After the longest bull market on record finally came to an end last week, Lenin’s famous quote concisely sums up the current mood among investors. The S&P 500 officially moved into bear market territory on Thursday after it breached the 20% level in a record 16 sessions of trading. Such price action reflects the tragic reality that the coronavirus has now caused the death of thousands globally, and the focus quite rightly is on limiting its human cost. Amidst the barrage of negative news, it is important for long term investors to act rationally and take account of the situation as it develops.

With Europe now officially at the “epicentre” of the pandemic, Spain and France have followed Italy in announcing emergency restrictions and wide-ranging economic shutdowns in order to limit the spread of the virus. European equities have been among the hardest hit, with the Eurostoxx 50 down 20.0% last week. By sector, Energy was the worst performer globally as the breakdown in talks between Saudi Arabia and Russia led to the oil price dropping to levels last seen in 2016. Banks also sold off which was an additional headwind for markets such as the UK which have greater exposure to Financials and Energy stocks.

The most peculiar aspect of recent days however has been the mixed performance of safe-haven assets which typically provide uncorrelated sources of return to risky assets such as equities and credit. Government bonds dropped 3.5% in price terms last week, with gold and silver also falling 8.6% and 15.1% respectively (although gold and US treasuries are still positive YTD). While asset price correlations can temporarily break down during periods of crisis, the dislocation between bonds and equities last week points to indiscriminate selling in the market.

This can occur for many reasons, such as: (1) systematic risk parity strategies will be cutting positions as volatility and correlations have risen (2) leveraged investors such as hedge funds are finding it harder to access capital (3) asset managers facing redemptions are being forced to raise cash and (4) the sheer uncertainty around the situation is creating high demand for cash as people are becoming more risk-averse. The latter point is best illustrated by the +3.5% outperformance of global “quality” stocks last week, which typically generate higher than average cash flows and are generally better placed to withstand economic downturns.

So, what is the best course for the rational investor right now? The most obvious conclusion is that things are going to be volatile across the board. Part of this will be in reaction to rapidly changing news flow about an unpredictable virus, but the extent of recent price moves (in both directions) suggests that greed and fear will be having an impact too. In that respect, it is noteworthy that hedge funds which attempt to profit from prevailing trends in asset prices are in positive territory YTD, despite the broader selloff.

The biggest risk in times of uncertainty is that is it easy for investors to lose sight of their long term objectives. While cash may seem appealing during a selloff, its value erodes over time in real terms, and the opportunity cost of being out of the market can be at least equally painful. Over the long term, share prices are representative of business fundamentals, and well-run companies will be able to weather the storm and come out stronger on the other side. With equities now looking significantly cheaper than they were a few weeks ago, now does not seem like the time to sell and lock in losses. Trying to time markets in this fashion is a highly risky strategy given current levels of volatility. Instead, the rational approach would be to keep calm, refrain from trading headlines, and remain mindful of your investment objectives.

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