Managing survival instincts during market volatility

Yesterday’s fall in the U.S. stock market was the third-worst performance day in history. It was sentiment-driven - as sentiment has been the market driver for most of this sell-off - and sentiment is just a nice way of saying fear. 

Fear, greed and fundamentals

It has been long said that fear and greed drive the market in the short-term. In the long run, however, fundamentals ultimately determine the price. When we say fundamentals, what we are really talking about is that the future earning potential of a stock will ultimately drive its value. Now, let’s use the S&P 500® Index as an example. At the time of this writing, the S&P 500 was at 2,410, which is 29% off from its 19 February high.

If fundamentals drive stock prices in the long run, then there is a simple question to ask: Will the negative impacts of the coronavirus reduce the future earnings potential of the average stock in the S&P 500 by 30%?  Easy to ask. More difficult to answer. We think the answer is no. But we believe we need targeted fiscal stimulus to minimise the potential damage.

Clearly nothing in this world is that simple in its entirety. Other questions like: were U.S. stocks too expensive to start with? This will affect how much return you expect from certain markets. But if we look to the future, we still believe that the earnings of the average U.S. stock will drive their stock prices to be superior to those returns in other asset classes.  In other parts of the world, the opportunity for high future returns are there, because they were not expensive to start with.

These are all good questions to ask, and we are asking them. But in the end, we believe that the future earnings potential of equities will drive returns superior to those of other asset classes.

That said, the near-term looks ugly. First-quarter global economic growth may end up being positive, but rather anemically positive. The second quarter is setting up to be a significantly negative quarter for global economic growth. If the virus follows the same path in Europe and the U.S., as it has in China and South Korea, then there is reason to believe that we will see the economy bounce back to positive growth in the third and fourth quarters of 2020.

That will be a lot of intense pain in a short period of time - and we are already feeling that pain in our personal lives. But will it really be enough to take away the average stock’s ability to grow earnings in the future?

Managing our survival instincts

Our survival instincts tell us that pain is bad and that we should distance ourselves from pain.This ingrained behaviour keeps us alive when our physical lives are threatened. The problem is that in too many cases, the fear overwhelms the intellect. That is why every individual investor behavioural study that I have seen, everywhere in the world, has come to the same conclusion: that we as humans buy high and sell low, and do it over and over again.

When greed dominates market sentiment, we take that as a sign that it is safe to buy, because that is what the herd is doing. When the market is falling precipitously on fear, as it is now, we feel compelled to sell for our own survival, and that instinct is confirmed by the fact the herd is selling. 

The main protections we have to combat this behavioural urge is a plan and a commitment to that plan. We have an investment strategy, and we diversify that strategy because we don’t know what will happen next. We have a plan because we know that if we do not have a plan in times like this, we will give in to the fear of others in the market. 

We do not recommend that you blindly follow your plan without question. That is not what we are doing at all. We are asking ourselves that same simple question: Will the impact of the coronavirus be significant enough to reduce the future earnings of the average company by 30%?

Let me say again that our answer right now is no. That answer could change if the fiscal response necessary to keep companies and industries in business and save the jobs of their employees does not come to pass. As I write this, there is over $1 trillion being discussed as a fiscal response to this issue in the U.S. alone.

The U.S. Federal Reserve (the Fed) has also announced that they will open up the commercial paper facility that they used in the Global Financial Crisis and effectively become the buyers of last resort for short-term financing vehicles. The market reaction has initially been quite positive to these developments, which were expected but nonetheless needed.

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.