February 28, 2020 - Fear, Greed and Common Sense

February 28, 2020
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Fear

As I write this, the stock market is down for the seventh day in a row and has declined approximately 12% from its peak on February 12th of this year. The severe selling that has taken place this week is extremely rare. Many commentators are likening this to the 2008-time frame. Although the swiftness of the decline may feel reminiscent of 2008, that is where the similarities end. This is not 2008! Fear of the unknown is currently gripping the markets. In 2008, we were dealing with the reality of major financial institutions going or potentially going bankrupt. Today the Coronavirus is the bogeyman and the investing community is not sure what that means in the intermediate to long-term or how to react to it today. When in doubt, many institutional investors just sell. Most of the selling is by large mutual funds and institutional money managers.  Whether this is a prudent long-term decision or not, only time will tell. The root cause of the fear and selling is the unknown impact the virus could have on corporate earnings 6-12 months from now. The concern is that this event could result in the recession that prognosticators have been predicting for the last several years. If you recall, between October 3, 2018 and December 24, 2018, the market corrected 20% due to fear of a potential recession in 2019. We all know how that turned out…no recession and the market was up 28% in 2019. As investors, we need to reset for a minute and remember that prior to this virus outbreak in China, the United States was experiencing one of the best economies in recent memory. The viral outbreak may result in a slowdown in economic momentum for a short time, but it is highly unlikely that it will derail it.

Greed

The other component to this sell-off is greed. Computerized trading, also known as algorithmic trading, is fueling this selling frenzy. This did not exist in 2008-2009 to the extent it does today. Also, after 2009, the government removed the uptick rule. The uptick rule prohibited short sellers (those betting a stock will go down in price) from making an individual trade to sell a stock short unless the prior trade had been positive or up. The removal of the uptick rule allows for large institutions to borrow stock that they don’t own and sell it without having to wait for the price to go up by a penny. In effect a buyer never has to surface, and they can keep hitting the sell button. The combination of the removal of the uptick rule and computerized trading has resulted in much more swift and severe down drafts in the market. Add to this the fact that computers can sell shares faster than humans and you have a recipe for extremely fast and severe moves to the downside. Selling begets more selling and the short sellers are making a ton of money along the way. Fundamentals, or how good a company’s financials are, go out the window and the computers take over. The aim of these short sellers is to buy back the stock for a much cheaper price after it has fallen precipitously and pocket the difference. They then return the borrowed stock to the institution they borrowed it from. Short selling is perfectly legal and has been going on since stock trading began in 1792; however, after the crash of 1929 rules such as the uptick rule were put in place to prevent the type of selling that led to the crash. To counteract the removal of this rule, amongst other reasons, the stock exchanges implemented “circuit breakers” that automatically halt all trading if the market declines by a certain percentage in a single day. This week’s daily activity, although large in point terms, was not very large in percentage terms so it did not come close to triggering the circuit breakers – only reaching about half the percentage decline required.

Common Sense

Just because the market got pushed around this week does not mean we take our ball and go home. Computerized trading works both ways and the market can go up just as fast as it went down. Short sellers are typically a temporary phenomenon and do not possess enough capital to have their way for an extended period. Ultimately cooler heads prevail, and the smart money looks at the bigger picture which results in a steadier market. We have stated many times to our clients that we are proactive money managers. We are not day traders, but our job is to actively manage your portfolio. During the corrections in both 2016 and 2018, we proactively made changes to our portfolios to limit the downside. A correction of 10%-20% is normal for the stock market. When we approach the 10% level, we closely evaluate whether this is a “normal” correction or something different. Obviously, what is transpiring today is a unique situation. A global viral outbreak is not your typical economic event. That being said, and given the above analysis, common sense must prevail. This week we made some adjustments to our portfolios, minor not major adjustments. We exited a few positions and rebalanced others. We are closely monitoring the situation and will make more adjustments as warranted. Our experience is that corrections like the one we are currently in, tend to be short lived and the rebound is usually fast and explosive (thanks to the computers). This is what happened at the end of 2018 and the beginning of 2019. On a positive note, today the Dow Jones Industrial Average rallied back in the last half hour of trading to pare what was a nearly 1,100-point loss to a 357-point loss. This may not seem like much solace but a 700+ point rally off the lows is a small victory for the market. Many of our portfolios were positive for the day.