Bear Territory: Equity Investment Outlook April 2020

Rarely has market performance and sentiment changed so quickly than what has been observed in the first quarter of 2020. The start of the year was promising, with the S&P 500 climbing above 5% through the middle of February. This performance came on the heels of very strong equity returns in 2019, in which the market gained more than 30% despite a lack of underlying earnings growth. However, the onset of the coronavirus has introduced a completely novel variable to both society and financial markets.

While there is little doubt the economy will struggle in the near term, the big question, and one that only time will answer, is whether the current disruption to our lives and the economy will be sharp but short, or sharp and elongated? Any prediction here is fraught with unknowns. On the one hand a high degree of economic damage has been discounted into equity markets and most economists are now calling for an economic contraction between 20% and 25% in the second quarter of 2020. The fiscal and monetary policy reaction is unprecedented and highly accommodative as the government seeks to build a bridge to the other side of this crisis. What we don’t know is the tail length of the virus and the shape of the recovery. Will the virus be contained quickly with a relatively quick return to normal life or will the virus itself and the aftereffects linger?

Another big story is oil. If it weren’t for the coronavirus, crude oil prices would be the story of 2020. Part of the decline relates to demand destruction brought on by the coronavirus, but Saudi Arabia’s actions to protect market share in its spat with Russia has been an added factor behind crude prices falling to levels not seen since 2003. While lower oil prices are positive for consumers and transportation companies, they are highly destabilizing to other parts of the economy. Energy companies quickly come to mind, but a fair chunk of the industrial economy is tied to oil equipment and services, and a strong ripple can also be seen in credit markets, where billions of dollars of energy debt are owned. The risk of financial contagion creates an “unknown,” and memories of 2008 are unsettling to financial markets.

The last big story of the year is the speed with which all of this happened. The 34% peak-to-trough decline from market highs has been truly breathtaking, and according to BofA Global Research marks the fastest time to a 30% or greater market correction in history. To put it in a more recent context, we looked at the VIX measure of market volatility, which typically spikes during market corrections. In the Great Financial Crisis, the VIX took about 100 days to rise from 20, the start of elevated volatility, to 80, its peak. In 2020 a similar rise took only 15 days! Much of this can be explained by overly bullish positioning heading into this correction, but the combination of quantitative investment strategies and leverage cannot be overlooked.