Developed world stocks have swung wildly from +4% to -4% this week, following the continued spread of Covid-19 and the Federal Reserve’s surprise announcement to cut interest rates 0.5%.
What’s going on here? Why do we have such wild swings in stocks and equity prices? There is a serious threat of a recession next year, brought on by the reaction to the Covid-19 outbreak, and investors need to understand that we are not out of the woods yet.
If you read our recent update about the Market Timing Model then you’ll be aware that there are a number of measures worth following rather than simply price. The price of stocks (or a stock market index) only tells you what somebody is willing to pay for it – and even if it falls 15%, that has no bearing on whether it will go up or down tomorrow. Value – what the value of the businesses future cash flows is, for example – that is what you’re really paying for and getting when you buy shares in a business.
What’s happened this week
For those of you who aren’t aware, let’s remember that over 50% of the entire world stock market is in the United States by market cap. In fact, according to the MSCI All World index that weighting is as high as 63%! The market capitalisation of the New York Stock Exchange is over $22.9 trillion, including behemoths like Apple, Microsoft, and Alphabet (Google).
American politics, tax policy, and interest rates matter to the world a lot more than people realise. The markets in the UK, EU, and to a lesser extent Japan and parts of Asia-pac are still well correlated with the US stock market.
So it shouldn’t be a surprise to find out that the main driver in developed world stock markets this week is three events happening in the great US-of-A:
- Joe Biden is highly likely going to be the front runner for the Democratic nomination
- Socialist-leaning
Bernie Sanders was looking like a favourite a few days ago
- Wall Street didn’t like the fact that Sanders might go after big business
- Former vice-president Joe Biden is viewed as a safer pair of hands
- Joe Biden might have a better chance of beating Donald Trump
- The Federal Reserve surprised the market by conducting an emergency cut to interest rates of 0.5% this week
- This
is a good news short term: it injects liquidity into the market and makes
loaning and borrowing money (in order to buy things) easier to do at lower
interest rates
- History suggests that the 1-month returns are generally positive (though not so far!)
- However, the reason for cutting is clear: the Fed sees trouble ahead
- Even worse, cutting interest rates doesn’t really do anything to fix the problem – Covid-19 is a supply side problem and its disruptions are majorly impacting supply chains.
Forward returns after an emergency Fed cut
According to the chart below historical returns 1-year out are generally quite poor, so be careful before jumping into the stock market too quickly:
The reason the Federal Reserve – the largest reserve in the world – has decided to cut interest rates is that they see a crisis developing and they want to get ahead of it. Just like they did in 2001, 2007 and 2008. The average returns after 1 year are -8.87% and the median returns are -11.71%.
As a result I’d be cautious pulling out the bubbly and celebrating a successful end to the current correction. History suggests that the average length of a bear market is 385 days, and the average fall is 35%!
- The spread of coronavirus (Covid-19)
looks to be taking root and moving towards a global pandemic
- Another Princess cruise ship was quarantined off the coast of California yesterday, after a former passenger died of the virus and became the first fatality in the US
- Case numbers in major developed economies continue to climb, adding strength to the argument that it is global (UK has 116 cases, US 228, Germany 349, Italy 3858)
- WHO Director-General Tedros Adhanom Ghebreyesus believes that we still have potential to halt the spread of the virus with government intervention and proper precautionary measures
- Mortality rate has jumped to 3.4% however that may be due to the fact that the number of cases worldwide is under-reported
Much like the panic buying that occurred in 2000 during the “Y2K” panic, what we are seeing here is more the human reaction to news than the substance of the news itself. Remember the threat that a glitch in computer systems was going to cause a global technology meltdown?
What we failed to realise in 1999 was that the answer was right under our noses. There was no real technical issue connected to a glitch in computer date-systems. In fact, the problem was quickly fixed. The stock market was at the highest valuation it had ever been – in history – and what followed was a crushing 2 year bear market that led stocks down by over 50%.
Covid-19 itself isn’t the issue, what’s problematic now is the reaction that people have to the virus, by not taking flights or travelling and not attending for sports events where they can spend hard-earned cash and keep the economy going. It’s like musical chairs – except this game is even more frenetic and the people keep turning the music on and off.
Buying stocks today is largely going against what the facts are telling you: there’s more risk to the downside here and the negative economic consequences of Covid-19 haven’t happened yet.
What it means for your portfolio
There are a few strategies you can follow that will help you be invested in this market now, while at the same time reserving the right for downside protection.
- Learn from the history books. Check out our reading list here.
- Ironically this is one of the lowest cost ways to get a first-class education on financial markets, investing, and how to retire early.
- As Warren Buffett has stated on numerous occasions, though, I bet few of you will take up the offer and grab these books for your own reading pleasure!
- Really truly understanding how to invest your own money takes time. Follow a blog like Frugal Investors and read some of the beginner’s books, as a starter for ten!
- Follow the Market Timing Model – 200 day moving average, and sell when the stock market falls below its 200 day moving average
- This registers SELL today – the S&P 500 index is 2972 against its 200 day moving average of 3051. Historically you are more likely to see further downside.
- For a detailed review of how the 200 day moving average works read here
- The problem is that you need to be comfortable with how it works and follow it every week, ideally, to ensure that you are aware 1. How the S&P 500 index is performing, and 2. Whether it has crossed the 200 day moving average.
- By following this method you are highly likely to out-perform the next bear market
- Invest in reliable dividend paying
stocks through the Global
Dividend Aristocrats portfolio
- Stocks that pay reliable dividends tend to overperform over the long run, according to our detailed analysis on how to build a rock solid investment portfolio
- Don’t focus simply on price: in the UK and EU dividends are especially high, and many dividend funds yield 3-4% per year. Over time this compounds wonderfully!
- Follow our full Market Timing Model
for weekly updates on whether to buy or sell stocks. We will be releasing an
update later today for last week
- The Market Timing Model looks at dozens of short term, and economic indicators, to review whether to buy or sell
- Our last update suggests investors keep calm, it’s not time to buy yet.
- At the moment the MTM suggests a SELL due to a number of factors, including increased volatility, bearish sentiment, and a high percentage of stocks reaching new lows. Until these measures turn around we could see further drops in stock prices
Conclusions
It is entirely possible that you could sell up now, everything you own in terms of stocks, and ride out the storm that is coming. That’s always extremely difficult to time: after all, unless you follow the Market Timing Model every week and religiously follow the measures, by the time you re-commit your money to the market you might be too late.
What this should instead give you is insight into when to commit fresh money to the market. At the moment this Frugalist Investor is sitting on 50% cash and using the MTM to figure out when the likely bottom arrives. It isn’t a perfect science, but when the coronavirus is in full force and panic begins to set in we may easily see another 10%-20% decline in stocks.
Rest assured when they do turn around we will be there with a megaphone to shout: BUY!
