On February 19 it looked like the stock market would break a new ceiling. The Dow Jones Industrial Average was headed to 30,000 and nothing could stand in its way.
Then the coronavirus stood in its way.
Over one week of trading, between February 21 and February 28, the market lost 3,500 points. Since then stocks have rallied and slipped depending largely on the day of the week. On two separate days (Thursday, Feb. 27 and Thursday, March 5) the market posted its largest single-day losses since the Great Recession. The question is… why?
The connection between COVID-19 and stock market prices is not immediately obvious. The industries most likely to suffer, such as airlines and hospitality, will almost certainly bounce back once the crisis has passed. Others have little, if any, apparent connection to infectious disease. Consumers aren’t immediately likely to need fewer computers or drink less orange juice in the wake of the coronavirus. Yet traders have sold those stocks anyway, unloading them at bargain-bin prices.
This happens. Sometimes.
A major crisis can have unpredictable effects on the stock market. Sometimes traders shrug off the event like it never happened. When Hurricanes Katrina and Maria made landfall in 2005 and 2018, respectively, the stock market largely didn’t notice. On the other hand, shortly after the 2010 earthquake in Haiti the S&P 500 lost 6.6% of its value, and the attacks on September 11, 2001 led to a 11.6% decrease.
At times, the market seems to ignore the headlines. Other times it seems to react with fear and panic, surging money out of stocks and into safe assets. Behind this unpredictability, often enough, is fear. Fear of unpredictability; fear of changing fundamentals; and, perhaps more than anything else, simple human fear for personal safety.
Traders Avoid Uncertainty
“In a broad, general sense, it’s that human nature is such that when we’re surprised by anything that we didn’t expect, our natural reaction is to react in a negative fashion. When something happens, and it can be anything really, our natural reaction is to hit the sell button… The coronavirus may or may not be any more dangerous, any more contagious, than the common flu, but it’s new,” Frederick said.
Investors, especially the professional and institutional investors who hold most of the stock market’s assets, try to trade on certainties. They rarely like to gamble, instead preferring to move based on a sense that they know where the market is going and how it will get there. This is why firms invest so much money in technical analysis. Modern traders work with numbers, assessing risk and reward based on enormous amounts of data.
Uncertainty undermines all of this.
When natural or political disasters strike, they create questions. Will supply chains remain stable and predictable? Will consumers still go out and spend money, or will they have jobs at all? Will lending tighten up? How will this affect property values and, as a result, the investments of both individuals and lending institutions? Economic conditions that, before, had been relatively well known suddenly become unclear.
In turn, that can make any investment position far less clear than it was before.
“Why do we buy stocks?” said Frederick. “We buy stocks on the prospect that the company will be profitable, and more specifically that it will be profitable in the future. If the coronavirus keeps people out of restaurants and out of stores where they might buy a brand of soda, it’s possible that company’s stock will go down over the next quarter, so maybe I don’t want to hold that stock anymore.”
“That’s the rational for any stock. You look at the prospects for the future and, if you’re optimistic, you own the stock.”
Uncertainty Drives Risk Premiums
Uncertainty in a stock is measured by what investors call “volatility.” High volatility means that traders just don’t know what’s going to happen. Prices could go up or down; the only confidence they have is that something will probably change.
“Volatility means movement,” said Lubos Pastor, a professor with the University of Chicago’s Booth School of Business. “It does not mean movement up, or movement down. It means movement in both directions, and I think the last three or four days are a perfect example of that.”
In times of high volatility investors tend to look for one of two things: more safety, or more rewards. It’s a trading metric called the “discount rate;” how much do they discount the present value of the stock based on the risks of holding it. That discount rate drives “risk premiums,” how much return do investors want in order to hold what they now consider to be a riskier asset?
“Basically in times of trouble people tend to apply higher discount rates [when they] value stocks,” Lubos said. “It’s a combination of two things. One is our attitudes toward risk, and the other is our perception of risk. The perception of risk is now higher. We now perceive stocks to be riskier than before because we just don’t know how stocks are going to play out.”
As to changes in attitude toward risk, Lubos said, “people often become more risk averse when they hear about major things like a virus.”
Investors Also Trade Emotionally
When the stock market falls in the wake of a political event or natural disaster, it reflects simple uncertainty on the part of traders. They don’t feel like they know what’s going to happen next, so they change their risk/reward calculations. Stocks that made sense previously no longer meet the new discount rates that firms apply to their position.
This is part of what’s going on.
It’s not that bloodless though. At the same time as investors run the new reality through their models and numbers, they’re also human beings. They tend to react just as emotionally as anyone else when frightened.
“You have to think about human behavior,” said Mark Hamrick, senior economic advisor with Bankrate. “We tend to think that a lot of this is scientific, and the scientific piece is the sort of unknowable role that algorithms and machines play… But with respect to where human behavior is involved, we know that it’s not an exaggeration to say that fear and greed help to drive a fair amount of market activity.”
“Here we are with what is truly the textbook example of a black swan, which ultimately is an event that was not largely expected and certainly wasn’t on the radar screens for anyone’s stock forecasts for 2020,” Hamrick said. “Ultimately, it’s an emotional response. I think that those of us that do step back from all of this try to remind ourselves, this too shall pass.”
Investors get scared when a new virus appears. They get scared when a hurricane flattens communities, when an earthquake shakes apart buildings or when a terrorist attack threatens their homes. Ultimately, even more than the technical analysis of risk vs. reward, short term positions vs. long, this may be the clearest explanation for why the stock market dips and when.
Like the rest of us, traders seek safety when they’re afraid.