by Connor Darrell CFA, Assistant Vice President – Head of Investments
U.S. equities generated their worst week in over a decade as fears that the novel coronavirus might pose a real threat to economic activity began to spread. In our view, the market action we observed last week was not based upon fundamentals, because market participants simply don’t have that type of concrete information available to them. The selling was, however, unsurprising as the panic that rippled through the financial system last week was likely amplified by the fact that equity markets had performed so strongly over the previous year. Throughout 2019, stocks generated strong returns despite minimal growth in corporate earnings. That happened because the global economy was showing signs of improvement and the prospects for future earnings growth were increasing. The coronavirus represents a significant unknown that is eating away at the positive sentiment that built up throughout last year, and investors should expect continued volatility in markets as the situation continues to evolve.

But with all of that said, while the coronavirus itself is new and the public health concerns very real, the fact of the matter is that what we are seeing in markets is not out of the ordinary. Since World War II, there have been a total of 26 stock market corrections (this one makes 27) with an average market decline of 14.3%. Some have been larger, and some have been smaller. What makes this correction particularly difficult is that there are so many details we still don’t know about the coronavirus. At what point will cases reach a peak?  How severe might the economic impacts be, and how widespread? The markets have reacted strongly to these uncertainties because investors’ appetite for risk tends to dissipate as more unknown variables enter the equation. In times like these, we like to remind investors that drastic portfolio changes are unlikely to add value over the long-term. In fact, there is overwhelming evidence that most investors make themselves worse off by reacting too strongly to negative news. The below chart from JPMorgan shows the historical performance of the average investor compared to a variety of different asset classes. The average investor has a propensity to act emotionally during periods of market stress and make efforts to time the markets, which has clearly led to significant underperformance. In fact, the average investors’ mistakes have caused portfolio returns to even lag inflation!

The evidence above suggests that investors should consider the amount of fixed income in their portfolios before making drastic decisions to exit equities en masse. For those who have multiple years’ worth of withdrawals that can be funded from bond positions, there is little that should be done to address the pullback.

by Connor Darrell CFA, Assistant Vice President – Head of Investments
It was a “risk off” week for global markets as stocks retreated from their highs and bonds generated positive returns amid growing fears of further spreading of the coronavirus. Many of those fears were realized over the weekend as evidence emerged of a substantial increase in the number of cases outside of mainland China, particularly in Italy, South Korea, and Iran. We have discussed in previous iterations of The Weekly Commentary that two key areas we are focusing on with respect to evaluating the risks posed by the virus are contagion and severity. In our assessment of contagion, our internal discussions have focused on evaluating whether containment efforts in China would be successful in keeping the virus from spreading beyond Chinese borders. The significant increase in cases outside of China over the weekend suggests to us that these measures have likely failed. As a result, we are increasing our assessment of geopolitical risks within our economic Heat Map from “Negative” to “Very Negative”.  Below, we provide further details of our current thinking.

Coronavirus Update: How Should Investors Be Approaching the Issue?
In our view, it is becoming increasingly likely that the spread of this disease will reach pandemic status, and many in the scientific community believe it is already at that point. There is of course a significant symbolic weight behind the word ‘pandemic’, and the simple reclassification of the current state of the coronavirus situation has the potential to strike fear into the general public. But by definition, the World Health Organization (WHO) defines a pandemic as simply “the worldwide spread of a new disease.” There is no specific standard that must be met with respect to the severity of the disease or its financial impact. It just needs to spread globally in order to reach the status of pandemic. We think that this is an important point to make, because that leaves open the very real possibility that a disease reaches pandemic status without the need for mass hysteria. In fact, the 2009 strain of H1N1 flu reached pandemic status with more than 60 million cases in the U.S. alone; and few if any of us look back at that pandemic and associate it with intense fear.

As investors, it is imperative that we disentangle our concerns for the near-term impacts on public health from our long-term expectations for markets. As a financial planning firm, we are long-term investors by nature. Everything we do for clients stems from the financial plan, which is constructed through a process that is designed to account for bouts of market volatility stemming from exogenous shocks (such as a pandemic virus) that may happen over the course of the implementation period. The beauty of the technology used by financial planners when constructing long-term plans is that we can test the resiliency of our plans across different scenarios, and those possibilities can be baked into the recommendations as well as into the construction of client portfolios. In our view, as long as a financial plan is properly constructed in a way that it aligns with an investor’s long-term goals, there should be no need for the investor to become overly concerned with the potential near-term impacts of these types of risks.  

The important assumption that is made in the paragraph above is that the impacts of the coronavirus will be near-term in nature. There are multiple reasons that we continue to operate based on this assumption.  The first relates to the severity of the disease. Looking back through history, there is really only one pandemic illness over the last 100+ years that was severe enough to unilaterally push the global economy into recession; and that was the Spanish Influenza of 1918. When we compare the data currently available on the coronavirus with what we know about the Spanish Flu, it becomes immediately clear that the two diseases are miles apart in terms of their severity. There are some conflicting estimates of the true severity of the Spanish Flu, but most suggest a mortality rate somewhere in the range of 10-20%, with significantly higher rates among certain age cohorts. The severity of the coronavirus remains somewhat difficult to fully evaluate given that it is an ongoing situation, but the current estimate is a mortality rate somewhere around 3%. Furthermore, the Spanish Flu is infamous among epidemiologists for being particularly deadly among younger, healthier adults. The data we have thus far regarding the coronavirus is that the mortality rates are significantly higher among older patients with compromised immune systems, much like the seasonal flu.

The second reason we continue to operate under the assumption of short-term impacts is recent history. An evaluation of several of the most recent viral epidemics (including SARS, H1N1, Ebola, and MERS) reveals that both economic and market impacts of the diseases could be measured in quarters rather than years. It would take a particularly deadly and long-lasting disease to alter the trajectory of economic output worldwide for more than a couple of quarters, and until we see evidence that this disease is capable of that, we are not sounding the alarm for investors to run for cover. It will continue to be important for investors to keep themselves informed of new developments, and it is our intention to provide as many updates as we can through The Weekly Commentary, but long-term investors should continue operating through a long-term lens. 

There remains the distinct possibility that additional news flow related to the disease could continue to weigh on equity markets, so investors who have near-term spending needs and plan to draw money from their portfolios within a year should make sure they have that money available in a low-risk investment vehicle. But for many others, an adjustment to the investment strategy should not be necessary. If you have specific questions related to your situation or a change in circumstances that warrants further consideration, your financial advisor is available to help you evaluate what the best course of action might be for your unique situation.