Effects OF The Covid-19 Pandemic On The Financial Markets
THE DANCE BETWEEN THE BEAR & THE BULL
In February 2020, we witnessed the peak of the biggest “Bull Run” (long, extended rise in the value of the financial markets) in the history of the United States. As it is often the case in periods of high enthusiasm, a large percentage of the investors expect that this trend in an upward trajectory will continue along the same path, which often contributes to forgetting the notion that past results do not guarantee future performance. Unfortunately at that precise moment the world was introduced to the consequences of the Covid-19 outbreak and the speed with which it was transmitted and the harrowing health hazards it created for the entire population of the planet. The leading world economies had to make strategic decisions in a very short time frame with serious repercussions against the new invisible “enemy”. The hysteria that ensued in the trading of the financial markets, the fear of swiftly rising unemployment rates and the start of the economic contraction all contributed to one of the fastest drops in the total value of the three “benchmark” indices in the period February - March 2020.
S&P 500 -34% / Dow Jones Industrial Average -37% / Nasdaq Composite Index -31%
In Bear Territory!
A “Bear Market” is classified as a prolonged drop in the value of the market in the investment lexicon. More precisely a drop of -20% or more from the peak value of the most important indices mentioned above. If that period is substantially prolonged and the appropriate measures are not taken it can push the economy into a recession or even worse a depression.
Continuous micro fluctuations are a normal part of the stock exchange and the financial markets. For context, it's important to note that the market has “corrections” (a drop of value) of -5% of the S&P 500 Index on average every year and 10% once every 16 months. These types of occurrences are nothing noteworthy and are part of the normal cycles of the financial markets. However, when there is a prolonged devaluation or a so called market crash like in the infamous 1929 “Wall Street Crash”, the bursting of the “Dot-Com Bubble” in 2000 or the Financial Crisis in ‘08, the consequences can be catastrophic because they enter into a self reinforcing downward spiral.
In contrast to the aforementioned dark ”souvenirs” of particular significance in Wall Street, the March 2020 Crash wasn’t provoked by speculative investments in one specific industry or inefficient and unethical practices of the large banks, but by a direct consequence of the panic created by the uncertain factors concerning the Covid-19 virus. The Pandemic along with the economic halt created by the restrictive measures and policies put in place to stop the spreading of the virus are one of the main catalysts for the crash of the financial markets in the period of February-March 2020. Although it could be debated that even before the first cases were registered on US soil, there were already potential signs of multiple factors that could have led to a negative influence on the stock market. Just to mention a few, national debt of 109.6% as a percentage of GDP in 2019, the trade and economic war between USA and China, US policy towards Iran as well as the stormy start to 2020 as well as having witnessed the longest bull run in history of about 11 years are all factors that showed a signs that perhaps the market was long overdue for serious correction from a statistical view point, however the pandemic was the main trigger. The normal economic cycle from recession to recession is about 5-7 years, so having a flourishing period of prosperity for eleven years speaks for the high probability of a market correction even if it was not for the crisis created by Covid-19.
Businesses were forced to close, a lot of employees lost their jobs (the number was around 22 Million people in the US between May - April) and the unemployment rate was the highest it has ever been since the Second World War (previously being at a record 50 year low of 3.5% before the outbreak). The fact that the USA became a global leader in the number of newly infected cases with a high percentage of deaths along with the near total closure of the most powerful economy in the world gave room for a perfect storm that led to the crash of the financial market and a serious blow to the world economy. Drastically reduced economic activity, record drop in GDP -31.4% in the 2nd quarter of 2020 as well as the serious reduction in corporate budgets along with the rise in unemployment created a scenario of dramatic reduction in purchasing power as well as having a psychological toll due to the mass uncertainty around the new reality.
If we add to the mix the widespread BLM “Black Lives Matter” protests as well as the civil unrest from the radically divided political parties culminating to the events in the period post Presidential Elections we saw a drastic reduction in productivity and consumption which further reflected negatively on the economy.
An interesting fact is that the fastest and biggest drop in the financial markets occurred in March 2020 when the majority of these situations didn't have clear indications on the effects to the economy, furthermore the effects of the Covid-19 pandemic were not yet clear. What that shows is the massive influence the psychological state of retail investors has on the price of the equities. The fear and panic of the unknown coupled with the belief that this time it's different had a lot to do with the fast sell off which in return attributed to the radical drop in the price of the indices and gave room to the self reinforcing downward spiral effect which may result in a large drop in the market value as was the evidently the case. In such cases, a large portion of retail and speculative investors in an effort to “save” what they can from their investments to escape the “claws of the Bear” begin selling their financial assets and positions en masse which in turn contributes to a further drop in the value of the indices.
In contrast to the past when trading on the markets was done manually, today transactions happen in nanoseconds and do not require a personal presence, simply access to the internet and an account with a licensed brokerage platform. Although this makes it easier to participate in investing on the stock market, in times of crisis it also reinforces the negative cycle and speeds up the drop in prices of equities during sell offs. That's why today there is a system known as a “Circuit Breaker '' which is an automated failsafe switch that has the aim to limit panicked sell offs and prevent horrific events such as the historic “Black Monday'' of 1989. The way the system works is if there is a drop in the price of the S&P 500 index of -7% from the previous trading day then the system activates itself and prevents trading in an interval of 15 min. If there is a further drop of -13% it stops trading for another 20 min. If it has a drop of -20% from the previous trading day then trading is halted for the day. Since this system has been in place, it has been activated once in 1997 and 2008, however in March 2020 trading was halted 4 times which speaks about the severity of the situation and the panicked sell off and subsequent market crash.
What's next? Total Covid induced crash of the US Stock Exchange? Financial Doom?
Absolutely not! Welcome to the fastest rebound in the history of the US Stock Exchange!
The new “Bull Run” and the sequential so-called “V” shaped recovery wouldn't be possible without the “matadors” in the form of the fiscal and monetary policies of the US Federal Reserve (FED), the Ministry of Finance and US Congress.
Historically, in such scenarios of crisis and dramatic drops in the value of financial markets the government resorts to classic monetary and fiscal policies. The first move by policy makers is the reduction of interest rates near zero which in turn stimulates borrowing and investing in productive assets, which leads to investments in financial assets.
The second lever they can pull is the so-called quantitative easing (QE) or monetary policy of devaluation of the local currency through the process of “printing of money” from the central bank with the aim to purchase financial assets. This process has the fastest stimulating influence on the financial markets and it is the main driving force for its recovery.
As perfectly summarized by legendary macro investor Ray Dalio (CEO of Bridgewater Associates - The largest Hedge Fund in the World), the 3rd part of monetary policy is the production of dept and creating debt monetization through which the Government aims to directly give aid to the individuals that are most in need in the form of “Stimulus Checks”. During this part of the process (Monetary Policy 3), the Government has much larger influence on the capital flows than it would have on the free market. The cooperation between the free market and the key government institutions is a symbiotic solution that is of huge importance when dealing and managing with a crisis of such proportions.
On the 27th of March 2020, then President of the USA, Donald Trump signed the so-called CARES- ACT (Coronavirus Aid, Relief & Economic Security Act) which amounted to an unprecedented $ 2 Trillion dollars, which marks the fastest approved such Act in the history of the US. During the Financial Crisis in 2008, the Government delayed their reaction and the passing of such an act (as it was the first time they were faced with such a situation) and this delay in the decision making process resulted in intensifying the severity of the crisis. That's why in 2020 the reaction and the passing of the Act was without precedent and of invaluable importance. This initial aid as well as the consecutive ones that followed through the year aimed at stimulating consumption that would restart the economy which led to a dramatic increase and recovery in the value of the financial market.
Maybe you are asking yourself why did the financial market explode while the economy is still unstable and the pandemic is in full flow?
The simple answer is that the Financial Market is not the Economy.
As Peter Mallouk has stated in his book “The Path: Accelerating Your Journey to Financial Freedom” (September 2020), the financial market is interested in one thing above all else, that is expected earnings, more precisely future profits. Simple put, the stock market is a reflection of the earning power of companies, everything else is just noise. The Economy on another hand is simply the sum of the total production, consumption of all its products and services, from individuals, companies and investments.
The art and science is in that the stock market and the economy are intertwined and influence each other but they are not in direct correlation. Furthermore, on the stock exchange we have “Publicly Traded Companies” and if we take into account the S&P 500 index for example those are the 500 largest corporations in the US, essentially the World. That means that the stock market does not account for the smaller privately owned companies that were predominantly in the hit zone of the Covid-19 pandemic.
To better understand the impact of printing of money from the central bank, we should look back to a very significant moment in history. In 1971 President Richard Nixon removed the US dollar from the Gold Standard. Until then the dollar could be classified as a hard currency as it was linked to its equivalent value in gold which means it could be converted for a fixed countervalue in gold. From that moment on the dollar has become what is known as a “fiat” currency that does not have any value against gold, silver etc. This enables the Federal Reserve (US Central Bank) to theoretically create an endless amount of dollars, however in practice that is not economically sustainable and that's why it must be thoroughly regulated. That creation of new dollars into circulation naturally devalues the currency. This itself can lead to hyperinflation however coupled with the devaluation of the currency, investors will be stimulated to invest their capital in the financial markets, purchasing stocks, bonds and other financial assets such as gold (which has been a historic hedge against inflation and market volatility) causing further inflation.
On another hand, large institutional investors try to seize the opportunity when there are distressed or undervalued assets in order to capitalize with larger sums. This improved sentiment is quickly mimicked by individual investors which begin to follow and re-enter the market more rapidly as they assume that that worst has passed. This begins to have a positive effect and equity prices begin to rise which in turn starts to attract the retail masses and speculators speeding up the entire process. The end result is a rapid increase in the prices of stocks.
The policies of the Governmental institutions accomplished their desired effect of reviving the financial markets which led to more positive investor sentiment in the short to medium term resulting in a record year for the US stock market in 2020. By the end of the year the three main benchmark indices S&P 500, Industrial Dow Average & Nasdaq Composite all reached higher peaks than their previous levels just before the crash.
Since 1928 until today, the S&P 500 index has had 26 bear markets followed by 27 bull markets right after of different intensities but with a significant increase in value per share price of the index long term. The key lesson being to stay invested at all times. The market has never taken money from anyone, doing your research, educating yourself and making informed and intelligent investment decisions over a long term investment horizon are strategies that ensure sustained success. As Charlie and Warren have stated, the only value of market forecasters is to make fortune tellers look good.