What investors should know about Black Swans and Pandemics

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On Friday, March 6th, I left the office to meet with clients across the nation. By the time I arrived home a week later, our world had changed. I went to the grocery store on Saturday and saw half-empty shelves and people keeping their distance from each other. While I am not a medical doctor, nor do I know what lies ahead, I hold on to the ancient phrase recounted by Abraham Lincoln, “And this, too, shall pass.”

The S&P 500 reached an all-time high of 3393 on February 23rd. From the bottom of the December 2018 correction, the stock market gained over 30% in fourteen months. We were due for a correction. With unemployment at record lows, company earnings generally on the rise, and low interest rates, a correction should have been in the normal range of 5-7%. What investors have experienced is an unprecedented three-week correction, the likes of which we have never seen before. What occurred was the swiftest 20% drop in U.S. history. Last week felt very similar to the most difficult part of the 2007-2009 financial crisis correction; however, this time it was caused by a virus and not a fundamental business reason.

During the bear markets of 2000-2002 (the “tech bubble”) and 2007-2009 (the “financial crisis”), the U.S. stock market lost more than 50% of its value over multiple months. The financial community blamed both drops on “Black Swan” events. As defined by Investopedia.com:

A Black Swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black Swan events are characterized by their extreme rarity, their severe impact, and the widespread insistence they were obvious in hindsight.

I have been managing client portfolios for a long time and experienced both of these Black Swan events.  Through a disciplined study of technical analysis, I am confident that Black Swan events and recessions can be forecasted, and investment loss mitigated. To me, what we are experiencing as a result of the new coronavirus (COVID-19), is not a Black Swan event; it is a pandemic

A pandemic is a disease epidemic spread across a large region, multiple continents, or the global community. We have experienced many such diseases since trading on the US stock market began, two of which are the Spanish Flu and the Asian Flu. The Spanish Flu occurred from January 1918 to December 1920. The stock market return during that time was +7.98%, with 1920 having the only negative annual return of -13.95%. The Asian Flu followed in 1957, driving stock market returns down 9.3% that year.

The selling caused by the spread of COVID-19 has been unprecedented in terms of typical stock market reactions to pandemics. With the advancement of mobile technology and the 24-hour news cycle, “real-time” information is constantly at our fingertips through TV and social media outlets. Fear of the unknown spreads rapidly and is apparent to everyone. What people (and investors) fear most is the unknown. In the past week, sports programs have shut down/canceled, schools have closed, airports have seen dramatic drops in travelers, and we are being bombarded minute-by-minute with updates. The fear is real. Pandemics, and their duration, cannot be forecasted. As history has repeatedly shown, life will eventually get back to normal, albeit most likely a “new normal.” The stock market will settle down, but it will take time.

Here are a few truths I gleaned from my experiences during the tech bubble and financial crisis, as well as lessons for investors from the 1987 stock market crash.

Where does that leave investors now?

Below, I offer a few potential outcomes of what could lie ahead for investors. By nature, precise outcomes of a healthcare pandemic are not predictable, the same is true of investment forecasting. Technical analysis of past bear markets points to the following:

Potential Scenario One: A repeat of the 1987 crash

I have found only one instance in which the market had a correction greater than 10% when the long-term technical trend was in a bullish pattern: the crash of 1987. There are some notable correlations between the correction of 1987 and the correction of the past three weeks. The stock market correction of 1987 had an initial correction of 15% in the early part of October, then a brief rally bounce, followed by a 20%+ correction. In the past three weeks we have experienced an initial correction of 15%, then a brief rally (Biden bounce), followed by a 20% correction. Due to the volatility of the market, it will take more time for technical chart work to catch up, but it does appear this initial correction is coming to an end.

I am a firm believer that the market has a tendency to follow past patterns. After the stock market crash of 1987 finished its initial correction, the market had multiple swings up and down in November and December of that year. In December, the market moved back to the initial low, but did not move lower. The correction’s low was reached and the market reestablished a new rally and made back all losses within three years. The United States did not experience a recession.

One big difference today versus 1987 is that we are experiencing a pandemic. It is possible that this correction could be coming to an end, and stock prices will not go much lower. Regardless, this pandemic has already had a dramatic effect on the world economy. It will be very important to monitor the developments over the months ahead.

Potential Scenario Two: COVID-19 pandemic causes a global/U.S. economic recession

It is too early to know the long-term effects that this pandemic will have on the world economy. Reviews of the last two recessions indicate that we are in the very early stages of a bear market. Both of the last two recessions lasted longer than 12 months and experienced a large rally after the initial correction. In long, drawn-out recessions, the rally following the initial correction tends to quickly make back 50-70% of the initial correction; then however, it returns to the lows established by the first correction, and can move quite a bit lower (as it did in 2000 and 2008).

Many have reached out with questions about buying the market. I do have some indication that this correction could finish within the next week or two.  For long term investors, the answer to this question is, you could consider buying. What is less apparent is the effect the COVID-19 pandemic will have on the economy ahead. No one can answer that. The probability of continued stock market volatility ahead is a given. The probability that the market will come back to whatever low is established with the initial correction is high. That said, due to the unknown factors of this pandemic, it is still too early to forecast the likelihood of us having a recession lasting a year or more.

On a personal note: Due to the contact I’ve had with the general public while traveling, even though I do not currently present any symptoms, I am self-quarantining out of care and concern for my family, clients, and staff.