As we are social distancing, a term that seems destined to be Merriam-Webster’s word of the year, it is easy to get swept up by gloomy economic headlines. It is a natural impulse, akin to rubbernecking on the highway. Just as rubbernecking grinds traffic to a halt, excessive worry causes us to miss the big picture.
The speed of price movements across all financial markets, equity, fixed income, currencies, commodities, etc. may be unsettling, and the sell-off is likely to produce anxiety as it conjures up visions of 2008 and even the Great Depression. But while the circumstances surrounding the current bear market are certainly unique, the nature of the downturn is not.
Three kinds of bear markets
According to research by Goldman Sachs, there are three kinds of bear markets: cyclical, structural and event-driven. It’s worth exploring each one as they tend to produce very different kinds of recessions.
Cyclical bear markets are associated with the normal fluctuation of the business cycle. If the economy gets too “hot”, the fed will raise rates to keep prices in line, resulting in a depressed outlook for economic growth and an associated sell-off. These types of bear markets have average declines of -31% and last on average 21 months.
Structural bear markets are caused by reversing a major bubble or imbalance in the economy. The 2008 financial crisis was such a bear market. Individuals and business were over-extended on debt as banks started lending to worse and worse candidates.
These types of bear markets tend to see deeper sell offs as they are correcting a fundamental flaw in the markets. On average, structural bear markets see declines of 57% and a 42 month recovery. The reason for the increased depth and time to recover is that even after consumers start to feel comfortable enough to spend more and businesses want to invest, banks are too impaired to lend, resulting in stagnation as the banks heal.
The coronavirus caused an event-driven bear market
Event-driven bear markets are caused by the market attempting to price in the impact of a specific event. The declines after the 9/11 attacks are one example. Event driven bear market sell-offs tend to be shallower, with an average decline of 29%, and the rebound tends to be much faster, averaging nine months.
Clearly, the current downturn is event-driven. The primary event has not so much been the coronavirus itself, but the containment measures around COVID-19, which are slowing economic activity.
This is, of course, a disturbing health crisis. Looking at infection rates in other countries, we can expect to see infections in the United States and abroad soar over the next 4-6 weeks. Fear of the disease itself seems to be impacting perceptions of the markets and their capacity for recovery.
A cause for optimism
However, data from China, Korea and Taiwan, indicate that social distancing along with testing will slow the spread of the virus. The administration believes COVID-19 will be largely behind us by late summer. From there, the outlook is a bit rosier. Government stimulus packages, deferred demand and ultra-low interest rates are likely to fuel a fast recovery in economic activity.
Much has been said about the unprecedented decision by Saudi Arabia to increase oil production in the face of declining global demand, brought about by the COVID-19 crisis. In previous years, this might have been a boon to economic growth, as lower fuel prices benefit the travel and manufacturing sectors.
However, the U.S. is now the world largest oil producer. Over the last 2 decades the U.S. has invested substantially in building out its energy infrastructure, which means that many banks and investors hold debt-backed energy infrastructure business. While Saudi Arabia can produce oil for as low as $3 a barrel, domestic “frackers” need oil in the mid-$40s to make money on new wells.
But this, too, is an event. Price fixing, by definition, is outside of the typical market cycles, and it certainly doesn’t represent the correction of a flaw in the markets. Once the oil crisis subsides, as seems likely to happen this year, we have the infrastructure in place for a rebound.
Looking for opportunities
So now that we have established a precedent for our current market conditions, we can look to identify opportunities. When markets sell-off, there are often exceptional opportunities for future returns.
Further, diversification seems to be working to stem some losses, as high quality bonds have generally rallied as equity markets have sold off. This provides an opportunity to re-balance portfolios, selling bonds that have become relatively expensive and buying stocks that come at a discount compared to only weeks ago.
Now is a good time to consider tax loss harvesting, using portfolio losses to offset gains in future years. Being able to use losses to save on taxes blunts the pain somewhat. With mortgage rates near all-time lows, it’s a great time to refinance. It is also a good time to consider a rollover from an employer plan to attain greater flexibility in your investments, or doing a Roth conversion to reduce your tax burden.
All of these moves only make sense if you can look past the headlines and see the market for what it is, an attempt to valuate a worldwide pandemic until such a time we have a vaccine or effective treatment. That day is coming, and its best to plan accordingly amidst the doom and gloom.