Techniques to weather market irrationality

People have been confined at home for weeks as the headlines have gradually become less negative and they’re waiting to find out a little more about what the real impact of COVID-19 will be on our “world” once the pandemic is controlled. For the time being, it seems too soon to venture to predict what the most serious repercussions of this health crisis will be because the most reliable source of predictions is often extrapolation from similar historical events. On this occasion, the unique nature of this crisis already known as “The Great Lockdown“ leaves us without any historical references. However, as Mark Twain said: “History doesn’t repeat itself but it often rhymes,” which serves to put into context the movements that have been observed in Equity markets and what their behavior may be in the medium- or long-term.

The severity of the falls in companies’ valuations and the indiscrimination with which they have occurred are unparalleled. The fact that the market has corrected more than 20 percent in just 23 days, that the S&P500 has closed eight days in a row with returns greater than +/-4 percent and that the VIX index (volatility index) has exceeded the 80-point level, leads to the conclusion that this is a unique and unrepeatable moment in time. And it probably is. Although to anyone who has danced to the rhythm of the equity markets for a few decades, this music will sound familiar. Because volatility is inherent in stock prices and falls above 20 percent are more common than you may think (the S&P500 has corrected more than 20 percent up to nine times in the last 50 years with an average fall of 35 percent).

What is the reason for this volatility in equities? Well, everyone knows that the price of a good or service is a variable that depends on supply and demand. For most goods, there are certain natural restrictions that prevent the price from fluctuating as much as supply and demand forces might indicate. Therefore, despite the skyrocketing demand for goods such as toilet paper, beer, or canned goods during this period of confinement, their prices have not varied significantly despite certain problems on the supply side. However, on the stock market, participants have very different biases and information flows so quickly that prices can fluctuate sharply almost without any limit to stop them (although in practice, there is a lower limit set at zero).

However, irrationality takes over when a stock market considered efficient does not distinguish the value price. In times of stress, this dislocation becomes extreme and the law of supply and demand does not serve as a mechanism to discern the fundamental value of the businesses in which investments are made, either directly or through mutual funds. Additionally, time horizons are shortened due to uncertainty and the investor begins to think in terms of days or weeks instead of months or years. Therefore, the price of a company that expects a cut in its profit by 40 percent for the next 12 months, falls on the stock market in a proportion equal to or greater than that percentage. However, most of the companies in which large mutual fund managers invest can generate sustained profits over time and this reduction in year-long results represents a very small decrease in terms relative to the real value of the business as a whole (even though the price indicates otherwise). Fortunately, the market tends to readjust these inconsistencies, although more slowly, so it is vital to be patient.

However, it is also irrational to think that there will be no winners or losers. Indeed, we are already seeing companies with strong balance sheets capable of self-financing, with strong competitive advantages and in sectors of structural growth that have been able to weather the first quarter’s falls better. Again, this is something that history has already taught us.

And we’re not just talking about winning companies. Investors who have received good financial advice will have realized how irrational it is to face changing markets without the help of a professional. And it is true that “no man ever steps in the same river twice, for it’s not the same river and he’s not the same man.”