Fear and Greed:  The human emotions that drive market extremes

For the week ending February 28, the S&P/TSX Composite Index declined 8.9% and the S&P500 Index declined 11.5%, marking the worst one-week performance since the 2008 financial crisis. It’s noteworthy that these same markets had just set new all-time highs the week before. While the sudden shift from extreme greed to extreme fear deserves explanation, our job is to pay greater attention to what comes next.

Starting in the Fall of 2019 and continuing into mid-February, we had been concerned that the rapid appreciation in stock prices was not supported by underlying fundamentals. Indeed, virtually all the 2019 stock market gains were due to multiple expansion (i.e. rising sentiment) rather than profit growth. Driven by greed, fear of missing out, or sheer momentum, our belief was that stock markets were priced for perfection. Like a rubber band that is over-stretched, mounting concern about the spreading Coronavirus (see page 2 for more) coupled with the third consecutive primary win by left-leaning Bernie Sanders culminated in panic selling that has wiped out the last six months of stock market performance.

With valuation and economic cycle analysis at the core of our asset allocation strategy, the equity weight in our model portfolios has been hovering in the 30%-35% range for the past several months. While we could not have predicted that a lethal virus would be the trigger for a stock market sell-off, we were concerned that the risk-reward trade-off was simply not attractive enough to warrant a high equity weighting. Fortunately, this defensive positioning has significantly dulled the impact of the recent sell-off on our client portfolios. By assessing the speed and magnitude of last week’s market decline, we think that genuine fear has crept into the marketplace. While the Coronavirus remains uncontained and U.S. political uncertainty is with us for another nine months, we do think that many excellent businesses are now trading at valuations that adequately reflect these risks (see exhibit 1 for a non-exhaustive list). Common traits among this short list are low reliance on global supply chains and/or significant cash on hand. We think the combination of these factors adds resiliency to these businesses. In the context of portfolio management, and to quote Warren Buffett, we think it’s time to be “greedy when others are fearful”. As such, we are preparing to gradually add equity exposure in the coming days and weeks.

Coronavirus: Spreading to more countries, but cases in China are falling

We are not epidemiologists and we don’t know how the current outbreak of Coronavirus will unfold globally. We do have access to up-to-date facts, market experience from the SARS outbreak in 2003, and current data to gauge the level of fear/euphoria gripping the marketplace. The latest data shows that the number of active Coronavirus cases in China (which accounts for 91% of global cases) are now declining (exhibit 2). Indeed, the number of patients in China that have recovered from the virus now outstrips the remaining number of active cases in the country. Data also indicates that the virus has spread to other countries, with the largest concentrations being in South Korea, Italy, and Iran. We, like many others, are closely monitoring virus related data and are prepared to dynamically adjust our investment strategy accordingly.

In addition to the human tragedy (the death toll was 3,000 as of March 1), the short-term economic fallout in affected regions is likely to be significant. Furthermore, restrictions on travel, disruptions to supply chains, and hit to consumer confidence will have repercussions throughout the global economy. The Chinese economy, the manufacturing hub of the world, is likely to experience substantial slowdown during the first half of 2020. Anecdotally, it appears that economic activity in China is slowly starting to come back online (e.g. Apple announced that it is reopening factories, Starbucks has restarted operations in 80% of its Chinese outlets), suggesting to us that a recovery should be underway in the second half of 2020. Governments have or are preparing to inject fiscal stimulus to soften the impact to GDP, and central banks are now assessing whether to inject monetary stimulus in the form of lower interest rates.

The question we face as asset allocators and portfolio managers is whether risks have been reasonably discounted. Only with the benefit of hindsight will we be able to answer this with a high degree of certainty. What we can assess is whether individual businesses, each with a unique business model and valuation, are worthy of investment after the sharp declines experienced last week. We think that the risk/reward relationship for select opportunities is now looking attractive. Furthermore, with our asset allocation positioned defensively going into the sell-off, we think there is capacity to increase equity exposure while still maintaining an overall conservative bias.

We understand that market gyrations can trigger anxiety. Our team is always available in person, via phone, or email to address any concerns you may have. We look forward to a thorough review of market conditions, your portfolio, and our investment strategy at your next portfolio review meeting.