Commentary | Jul 07, 2020

Round 1 Goes to Fear and Round 2 Goes to FOMO

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Round One Goes to Fear

Prior to the COVID pandemic, it had been some time since investors felt anything close to the level of fear that gripped markets during the global financial crisis of 2008. As global stock indexes plunged over 30% from their late February 2020 peak in little more than four weeks, media pundits and investment managers were predicting Depression-era scenarios.

Round Two Goes to Fear of Missing Out (FOMO)

Just as investors were fearing the worst, the cavalry (primarily in the form of the Federal Reserve and the US Treasury) saved the day, unleashing an unprecedented amount of both monetary and fiscal stimulus. These initiatives gave a strong boost to risk assets, which were deeply oversold on a short-term basis. As markets initially bounced off their late March lows, there were few optimists. As stocks continue to climb to within striking distance of their pre-pandemic highs, many investors have not only become less fearful, but have embraced the notion that stocks have significant upside potential over the near to medium term. Refrains of “Don’t fight the Fed” and “Powell put” have gained increasing acceptance and have caused many market participants to shift from fear to FOMO.

For What It’s Worth (this has nothing to do with the way we manage money…but we can’t resist)

If it turns out the worst is indeed behind us, this would be the first bear market that put in its lows within five weeks of its pre-selloff peak. After the dot com bubble burst, it took the S&P 500 Index approximately two and a half years to finally hit bottom in October of 2002, at which point it had declined 47% from its March 2000 peak. During the global financial crisis, it took the index about one and a half years from its July 2007 peak to finally bottom out in March of 2009, by which time it had suffered a decline of about 55%.

To be clear, we are not insinuating that the massive monetary and fiscal responses that have occurred are irrelevant or that, all else being equal, they are not positive for markets. But the trillion-dollar question is whether they justify the stock market’s 45% gain from its late March lows (in the case of the S&P 500 Index) and the halving of high yield bond yields. Without going into an exhaustive list of positives and negatives, it is probable that markets have over discounted good news while under weighting potential risks. In our view, at current levels the odds aren’t in investors’ favour. There is a distinct possibility that the mighty market brontosaurus has been bitten on the tail, but that the message has not yet reached its tiny brain. This is not to say that markets can’t creep higher, but merely that the probability distribution is unfavourable.

Einstein’s Definition of Insanity

Regardless of whether you think that markets are going higher or lower over the short, medium or long term, what is clear is that the current level of uncertainty is elevated if not extreme. There are a myriad of factors that could spur a sharp drop in stocks and other risk assets, including (but not limited to):

• A second wave of Covid-19.
• The inability to develop an effective vaccine in the near-term (if ever).
• A slow and painful economic recovery attributable to the permanent closure of many small business and permanent loss of millions of jobs.
• A repeal of Trump’s corporate tax cuts and an increase in capital gains taxes (not market friendly), brought on by a Biden victory (and perhaps a Democratic Senate).

Given this high level of uncertainty, it is somewhat paradoxical that stock markets are not far from their pre-pandemic highs. According to legendary investor Jeremy Grantham, who was successful in identifying the pre-crash bubbles of 1999 and 2007, “Uncertainty has seldom been higher…oddly, neither has the stock market.” Risk management and adaptability are particularly important in uncertain times. Conventional buy and hold, “we own fundamentally great companies for the long-term” portfolios have always been crushed in bear markets, and will inevitably suffer the same fate during the next debacle. Albert Einstein stated, “The definition of insanity is doing the same thing over and over and expecting different results”. If you are uncomfortable risking such an outcome, then there is no time like the present to reevaluate whether your managers can protect you from large losses if markets turn ugly.

Making Bear Markets Bearable

The Outcome Metric Asset Management strategies rely on big data analysis and machine learning to develop and refine investment models and decision rules that can grow our clients’ capital while protecting them from large, bear market losses. We are pleased that we have achieved these objectives, both through the challenging fourth quarter of 2018 and again during the first quarter of 2020. We are confident that this approach will enable us to continue delivering superior risk-adjusted returns over the long-term.