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Written by: Kelly Ye, CFA
First and foremost, all of us at IndexIQ hope you, your families and your colleagues are staying safe and healthy.
The human tragedy of this ongoing crisis, laid bare in staggering daily updates on the number of people sick and dying, is difficult to comprehend. We applaud the medical personnel and all those working on the frontlines to help the sick and seek out potential cures. How long we will all be living and working under this shadow, we do not know, and we do not venture to guess. Questions like those we leave to the experts in epidemiology and medicine. But we did want to take some time today to provide what we hope is some helpful context on the economic side of this discussion. After all, the economic impact of all we are currently living through will have consequences as well.
The investment markets are a highly visible attempt to quantify that impact. Because little is known for certain about what course the disease will take over the next few months, stocks and bonds have been understandably volatile and are likely to stay that way until it’s clear the corner has been turned.
Of course, an investment portfolio isn’t just about money; it’s about what can be done with that money: paying for a child to go to college, buying a home, or, over time, providing for a comfortable retirement. When these goals suddenly become threatened, panic often ensues, and panic begets panic.
The coronavirus, and the abrupt decline in global economic activity it has engendered, is the most obvious cause of the market’s dramatic decline, but other factors have contributed as well. Those include a poorly timed oil price war initiated by Saudi Arabia, the low-cost producer; the uncertainties created by the upcoming presidential election; and a bull market that had passed its 10-year mark. Collectively, these events drove the S&P 500 down 20% in less than a month, and the CBOE Volatility Index (VIX), the “fear gauge,” up above 50 for the first time since the great financial crisis in 2008 (Mar 2, 2009. Note the last time it topped 80 was Nov 20, 2008). In fact, the VIX hit 82 on March 16th, highlighting the extraordinary stress in the markets.
A common challenge for investors coping with market moves of anything approaching this magnitude is that assets that are thought to be non-correlated in normal times start to move in the same direction at the same time. This was true in the 2007-2008 financial crisis, and it has generally been true in the early stages of the current volatility. Still, some strategies have managed to maintain a low correlation with the broad market, including those that focus on liquid alternatives.
So there remains value in diversification, even in a crisis, though it may not always be apparent in the heat of the moment. In the 10-year bull market just ended, an all-in commitment to the S&P 500 would have mostly worked, until suddenly it didn’t. Major market moves are like this – nearly impossible to predict. They do, however, tend to draw a line under the advantages of staying diversified. The benefit is not just in delivering non-correlated returns over time, of nearly equal importance is the impact it can have on investor psychology in times of stress. Fear of loss can cause reflexive selling, generally the worst thing an investor can do. To the extent that liquid alternatives help soften the blow, it makes it easier to resist the impulse to sell assets into an unpredictable market. It helps you stay disciplined in your asset allocation.
Every crisis is different in some ways, but alike in others. There’s a triggering event, a sharp decline, and usually a few halting attempts at recovery before a sustained upturn again takes hold. We see this general pattern in most every major market sell-off over the past century. What differs is both the catalyst and the time it takes to recover. What has not changed – so far, at least – is that recovery has come in time, and that diversification has been a valuable tool, both on the downside and on the up. The current crisis is in some ways unprecedented in that it’s built on a threat to human health. But as we have noted before, unprecedented events tend to occur with some regularity. Speaking strictly to the investing side of events, we believe that the formula for navigating markets under stress has not changed that much: focus on long-term goals and stay diversified.
Stay safe and healthy.