Another Crisis
The coronavirus pandemic has sparked an unprecedented level of panic that is being compared to days leading into the financial crisis. Rich, Steve, & I discussed the panic and what to do next. We recorded the conversation (transcription below).
What would you say is the number one question from clients right now?
The one I’m hearing the most is if this is “another 2008.” Could this pandemic cause another financial crisis?
Could it?
The odds are incredibly low. Let’s go back to 2008 and talk about what caused the mayhem. It wasn’t subprime mortgages, or the Fed raising interest rates, or consumers and businesses having way too much debt. That all caused the recession, but what made everything so crazy, what turned it into the worst crisis since the Great Depression, was a crisis of confidence.
The entire financial system is based on trust. We put our money in banks trusting it will be there when we need it. Lenders loan cash to people trusting they will be repaid. Back then, there were decisions made by regulators that caused this trust to crumble. That is not an easy thing to do and hadn’t happened since the late 1920s.
To think that a pandemic that has so far only really posed risk to those with pre-existing conditions, and now showing declining rates of infection in China, is a stretch. Don’t get me wrong. This is serious. But it pales in comparison to even the 2018-19 flu season right here is the U.S.A. Back then, 42.9 million people contracted the flu, 647,000 required hospitalization, and 61,200 deaths resulted1.
I just don’t see how the coronavirus can cause the financial system to crumble like it did in 2008. Will it really cause people to fear that their bank accounts are no longer safe?
If not a financial crisis, what about a recession or some type of prolonged economic decline?
I think the risk is low. If this situation gets materially worse, then it will most likely impact the U.S. economy. For example, if the CDC were to order nationwide closing of schools and daycare centers, which from what I understand is protocol, then this is going to impact the economy. Anyone with kids will be stuck at home not working but more importantly not spending money. Around 70% of our economy is consumer spending. Buying that Starbucks coffee or new iPhone. That all drives our economy forward.
If it got bad here, most purchases would probably end up being delayed rather than destroyed. If I want the new iPhone but a manufacturing shutdown in China keeps the new model from being on the shelf, it’s not like I am going to cancel my Verizon contract. I’m just going to stick with my old phone and wait until the new one makes it to the Apple store. This type of behavior slows down the economy but only temporarily and tends to get made up down the road. It’s delayed not destroyed. Any investor who can be patient should not fear this type of economic slowdown because it probably won’t last.
Wellif it's not looking like another 2008 or even a recession, why does this time feel so different?
Good question. And I agree. Investors have also told me that this volatility feels more serious than some of the other ones we’ve seen over the years like North Korea, U.S. debt default, or even other pandemics like the Ebola scare.
I’m 50/50 here. Part of me disagrees because the structure of the volatility has been pretty consistent with prior panics. During times of extreme stress, big up days and down days are clustered very close together. We are seeing that right now. Traders feed off this volatility and tend to even like it.
Wait. Before I go any further, for those out there with any urge to try to trade on days like these, don’t even think about it. Mom and pop day traders have to now compete against PhDs from MIT and Stanford, using artificial intelligence on million-dollar computers to trade at fractions of a microsecond. You’d be bringing a butter knife to a gun fight.
But it does not feel exactly the same either. I have to admit that this volatility does seem more violent than in prior drawdowns.
Any idea why this is the case?
I think it could be an unintended consequence of a dominant trend we have seen over the years. Which is this move to lower cost index funds and away from active managed funds with higher fees. This has been one of the biggest stories in the investment world over the last decade. Especially the last three years or so. Investors were fed up paying for active managers who could not beat the S&P 500, so they moved to ultra-cheap passive funds that simply track the S&P. This works well in markets that keep rising. But nothing works perfectly all the time.
The problem is that so many investors that have piled into these funds don’t fully understand the risk in passive funds. There is ample data out there to support this. Capital Group, one of the largest asset managers in the world, conducted a survey that produced two alarming statistics 2 .
First, 75% of those over 65 consider protecting gains from market downturns a priority. This make sense, right? If I am retired, I have less tolerance for big swings in the stock market versus a Millennial.
Second over 50% of respondents were aware that index funds expose investors to the full ups and downs of the market Meaning, if the S&P 500 is down 38% like it was in 2008, then an index fund that tracks the S&P 500 will also be down 38%. My point here is a lot of investors who moved to passive vehicles to save on fees are now exposed to the exact thing they want to avoid.
Now this wasn’t much of a problem over the last few years because markets kept going up for the most part. But a spike in volatility like this one has probably caused people to realize that they are not protected, and they panic. It’s like throwing gasoline on a flame, and I think this is having an effect on recent volatility.
In fact, I’ve been talking about this for some time now. I wrote a paper in the summer of 2019 that explains how passive funds work and exposes the misconception that these funds are somehow less risky. I even created a simple three question test to help investors determine if passive strategies are a viable option.
Can our investors get a copy?
Of course. Happy to email a copy to anyone interested.
But let me be clear. This is not me, an active manager, beating up on passive fund. In fact, I am not only a big believer, I use them extensively. I love index funds. They allow active managers to get super cheap exposure to an asset class with built in diversification.
For that matter, if you are a 30-year-old with decades to go, you probably don’t need to pay for an active manager. Buy a super cheap index fund, ignore this volatility, and sit back and relax. But if you are either retired or about to retire and need to plan income, a passive approach is simply impossible in today’s markets.
The dividend yield on the S&P 500 is currently around 2%, and the yield on the Barclays Aggregate Bond Index, which is kind of like the S&P 500 but for bonds, is not much better. That means no combination of a passive strategy in stocks and bonds can generate enough income to exceed any realistic measure of inflation. Especially after taxes. I don’t see this changing for quite some time.
What about the Fed? They did an emergency rate cut this week. Japan is also using monetary policy to try to calm people down. Is this going to work?
I believe this will have no effect. Emergency rate cuts cannot fix emergencies. The Fed has tried this before. It hasn’t worked before and I don’t see why it would now. They are trying to use penicillin to cure a virus. Pun intended. We may just have to wait for this pandemic to run its course.
What can investors do until then?
Well I’m hearing a lot of advisors and strategists telling investors to “stay the course” and “this will all blow over.” While I agree, I’m not sure this is the best strategy for all investors.
Volatility on its own does not warrant a shift in strategy. What does, and this where you need to be honest with yourself, is if it is keeping you up at night. If you are looking at your account statements and feel like you want to run to cash, book an appointment with your financial advisor and have a real talk about options that may be better suited for you. Because running to cash will do nothing more than lose money safely. Like I just said, returns in cash investments probably won’t beat inflation for the foreseeable future. This loses purchasing power. Not a good thing for those in or around retirement. Let’s go back to the financial crisis for a moment. What really caused people to lose so
much back then? It wasn’t the evil hedge funds, or massive debts, or subprime loans. None of that. People lost money because they were out of their comfort zone. They misjudged their ability and willingness to stomach volatility and sold into the panic. It is that simple.
This is why investors don’t meet their financial goals. Same thing as today. It’s not pandemics or Iran or North Korea or Brexit or any other reason the market panics over time. They miss their goals because they have a right shoe on a left foot. This causes them to make an emotionally fueled decision that does little more than turn short term pain into long term misery.
Three Key Points
Fears that the coronavirus could cause another financial crisis are widespread.
This time does feel different.
Volatility on its own does not warrant a shift in strategy.
Sources
U.S. Centers for Disease Control and Prevention
Disclosures
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, accounting, or other financial advice. Richard W. Paul & Associates does not provide tax, legal or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.
Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance. Consult your financial professional before making any investment decision. This material is for informational purposes only and sets forth the views and opinions of our investment team as of this date. The comments, opinions and estimates are based or derived from publicly available information from sources that we believe to be reliable. All indexes are unmanaged, and an individual cannot invest directly in an index. Index returns do not include fees or expenses. Investing may involve risk and may result in the loss of principal.
Advisory services offered through Richard W. Paul & Associates, LLC, a Registered Investment Advisory Firm. Insurance services offered through Midwest Financial Consultants, Inc. The aforementioned are affiliated companies.