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“Beware the Ides of March”
The emergence of SARS – CoV – 2, the new coronavirus infecting human beings, poses significant challenges to modern societies in terms of epidemiology and health, economic growth, and human psychology. As of this writing (March 16, 2020), national governments are responding vigorously to this virus, to understand its biology and its impact on humans, to slow the spread of the virus (although it is now global in its distribution), to treat infected individuals, and to develop and distribute a vaccine. In an age in which travel across the globe can take just hours and the flow of information in just seconds, medical professionals, policy makers and government leaders face significant challenges in managing both the biological impacts of the virus on humans and their psychological responses to it.
I am interested in how the capital markets are responding to the new circumstances and, in particular, how the markets respond to the uncertainties posed by the coronavirus and the disease it creates in human beings, COVID – 19. In this blog, I offer some preliminary thoughts about how markets behave in the face of such new and adverse conditions, especially those for which the dimensions are not full seen or understood and may be outside the boundaries of our collective experience.
Coronaviruses
According to the United States Centers for Disease Control (CDC), “coronaviruses are a large family of virus that are common in people and many species of animals, including camels, cattle, cats and bats.” (1) Coronaviruses that originate in animals do not often infect humans though, in two recent situations, that cross-species infection did occur: infections by the MERS virus (termed MERS -CoV by the CDC; MERS refers to “Middle Eastern Respiratory Syndrome”) were first reported in 2012 and infections by the SARS virus (SARS – CoV; “Severe Acute Respiratory Syndrome”) first reported in late 2002.
The new coronavirus, termed SARS – CoV – 2 by the CDC, is a betacoronavirus, as are MERS – CoV and SARS – CoV. The cross-species infection by SARS – CoV – 2 appears to have begun at an animal and seafood shop in Wuhan, China and the virus has spread to virtually all parts of the globe through human-to-human contact. The CDC suspects that the original infection in China came from exposure to one of the common mammalian carriers of coronaviruses, likely a bat.
In humans, coronaviruses typically cause mild symptoms from which patients easily recover. However, both SARS and MERS can cause pneumonia and possible death. For example, SARS - CoV killed 916 of 8,422 people infected in 2002-2003 (10.8%) (2). According to the WHO, the number of people infected with MERS since September 2012 is 2,494 of which 858 are fatalities (34.4%) (3).
The infection rates and fatality rates of COVID – 19 grew steadily in the early period of contagion, especially in China, after a pneumonia of unknown cause detected in Wuhan, China was first reported to the WHO Country Office in China on December 31, 2019. On January 30, 2020, the World Health Organization (WHO) declared the outbreak of COVID – 19 to be a “public health emergency of international concern (PHEIC)”. The next day, U.S. Health and Human Services Secretary Alex M. Azar II declared a public health emergency (PHE) for the United States to assist aid the nation’s healthcare community in responding to COVID-19.
Several important developments unfolded in March 2020:
There were rapid increases in the number of infected individuals in Italy and Iran.On March 9, the Italian government took aggressive action to limit travel in and out of the country and within the country itself.
Infections rose in many other countries as well, including the United States.
It became clear that COVID – 19 is especially virulent in older people and those with compromised immunological or respiratory systems.
The WHO declared the global outbreak of COVID – 19 to be a pandemic, or “the worldwide spread of a new disease.” Importantly, neither SARS – CoV or MERS – CoV created a pandemic though H1N1 Swine Flu did.
The U.S. Federal Government acted decisively in declaring a national emergency, introducing liquidity into the financial system through emergency cuts in interest rates, and releasing funds to support the economy.
Financial Markets
As of mid-March 2020, financial markets are experiencing a “flight to quality,” in which investors are moving their capital away from risky investments (such as equities) to safer ones (such as cash or Treasury bonds). Flight to quality is often caused by uncertainty in the financial markets, as investors seek to preserve their capital.
Since the initial outbreak of COVID – 19, there has been high volatility in equities markets with most major stock market indices well down from their record highs and some reaching into “bear market” territory (down by at least 20% in mid-March 2020).
In Figure 1 below, I show weekly prices for the S&P 500 stock market index from January 2000 to March 2020. It is clear that there are only three major corrections in the market during these two decades: (1) the crash of the market following the failure of Lehman Brothers in September 2008 which reached “bear market” levels (down 20% or more); (2) the correction in 4Q2018 attributed to the trade war with China; and (3) the bear market of 1Q2020 associated with the SARS – CoV – 2 pandemic.
Figure 1
Notably, the H1N1 Swine Flu pandemic was not associated with a market correction, nor were the outbreaks of SARS and MERS.
Notably, trading was halted on the equity exchanges several times in March to slow the tide of very aggressive selling. On March 16, 2020, the Dow Jones Industrial Average fell by more than 2800 points (12%) at the opening of trading and the S&P 500 market index fell by 10.6%, causing trading to be halted. Previously, trading had been halted on both March 10 and March 12, again in the face of aggressive selling.
The Volatility Index, or VIX, of the Chicago Board Options Exchange spiked in the last week of February 2020 and continued at very high levels through mid-March (Figure 2). These recent values are second only to those in the Financial Crisis of the late-2000s.
Figure 2
The VIX Index is a measure of the market’s expectations of forward volatility on the S&P 500 (measured on a 30-day perspective) derived from options on the S&P 500. Often termed the “fear index,” the VIX measures the uncertainty of the future direction of the S&P 500. High values of the VIX Index represent high levels of uncertainty about the future direction of the market; low values of the VIX represent low levels of uncertainty.
Following the collapse of Lehman Brothers in 2008, the VIX Index reached historic highs and occurred simultaneously with a bear market in the S&P 500 (Figure 1). This same dynamic appears to be happening in the current market: the appearance of SARS – CoV -2 is associated with a spike in the VIX Index (Figure 2) and a bear market in equities (Figure 1).
Notably, other viral outbreaks and pandemics did not cause increases in the VIX Index or declines in the stock market.
Interest rates on 10-year Treasury bonds have fallen sharply as investors moved out of risky assets into the perceived safety of Treasuries (Figure 3). Since the price of a bond moves inversely with the yield on that bond, we can surmise that the price of the 10-year Treasury moved up dramatically with the emergence of SARS – CoV -2 and the onset of COVID – 19.
Figure 3
In fact, the drop in Treasury yields appears to be sharper than the comparable drop following the failure of Lehman Brothers in September 2008.
Investors are behaving as they have behaved in the past in seeking safety in times of turbulence, though in the case of COVID – 19, the movement appears to be exceptionally sharp and rapid.
Uncertainty in Financial Markets
In finance, “risk” is defined as the chance that a market outcome or the return on an investment will differ from an expected outcome or return. In this sense, “risk” is synonymous with “uncertainty.” Risk also includes the possibility of losing some or all of an investment.
Statistically, risk usually is measured through analysis of historical data on outcomes, including investment returns. The variance or standard deviation (standard error) is the common metric associated with risk. For example, the standard deviation of asset prices provides a measure of the variability of those prices in comparison to their historical averages over a specific period of time. Further, the confidence interval (a multiple of the standard error) shows the uncertainty associated with a given statistic, such as an average.
Importantly, because we can measure the historical outcomes that give rise to the average and standard deviation of those outcomes, we know about those events. In this sense, the uncertainty is knowable.
But there is a second type of uncertainty, the uncertainty that is unknown or unknowable.
Knightian Uncertainty
In contrast to uncertainty that we term “risk,” “Knightian uncertainty” describes the lack of measurable or quantifiable knowledge of possible outcomes. More precisely, Knightian uncertainty implies a degree of ignorance about, and the inability to know about, future events.
Knightian uncertainty is named after Frank Knight, an economist at the University of Chicago who distinguished uncertainty from risk in his book, Risk, Uncertainty, and Profit (4). According to Knight, the term risk applies to a future circumstance for which the outcome is unknown but for which the probabilities of different outcomes can be quantified from similar circumstances that have arisen in the past. In contrast, uncertainty applies to situations where we do not have, or cannot know, all the information we need in order to establish the probabilities of future outcomes.
Because “risk” and “uncertainty” often are used interchangeably, I will use risk to mean knowable uncertainty in the sense that Knight described it and I will use Knightian uncertainty to mean unknowable uncertainty.
Knightian Uncertainty in Financial Markets
Financial markets experience risk every day and, so long as future circumstances are expected to operate within the range of experience, the markets can price for that risk and thereby manage it. Rarely, however, circumstances arise that are outside the experience of market participants and, thus, cannot be quantified and managed. In these circumstances, flight to quality can be extreme.
One recent example was the subprime mortgage crisis in the mid-2000s. Leading up to the collapse of the subprime market in 2007, many market participants believed that the values of homes in the United State would only increase as such increases had occurred consistently for decades. Importantly, declines in national home prices had not occurred.
In fact, the only time since 1900 that national home prices had actually fallen was in the 1920s, just before the collapse of the stock market and the start of the Great Depression. Importantly, these declines occurred well beyond the memory of market participants in the 2000s. In addition, there were few data on home values in the 1920s available to investors in the 2000s, so there was little opportunity for those investors to determine the variability of housing prices and, thus, the risk associated with investing in residential real estate.
When housing prices did begin to fall in 2007 due to defaults emerging from aggressive lending practices of the mid-2000s, including poorly underwritten mortgages, investors both were surprised and had no reference point to determine the range of possible outcomes if prices fell further. The natural flight to quality was exacerbated when two U.S. investments banks, Bear Stearns and Lehman Brothers, both failed due to high exposure to mortgages gone bad. Numerous monoline mortgage lenders suffered the same fate.
Flight to quality was so extreme that the S&P 500 fell by more than 25% and investors bid up the prices of Treasury bonds to a point that their nominal yields fell below the rate of inflation and inflation-adjusted returns turned negative.
Does COVID – 19 Create Knightian Uncertainty?
Yes, I think so, for several reasons.
First, although the COVID – 19 pandemic is the seventh viral outbreak since 2003 (SARS - CoV, Avian Flu, H1N1 Swine Flu, MERS, Eobola, Zika, and now SARS – CoV -2), it is only the second outbreak to be labelled as a pandemic (H1N1 Swine Flu being the other). And the markets appear to have understood the global nature of the SARS – CoV – 2 pandemic long before the WHO labelled it as such.
Even though we have a sense for the range of outcomes for historical viral outbreaks, such as rates of infection and mortality, the market appears to anticipate outcomes for COVID – 19 that are worse than past experience. Historical rates of infection for other outbreaks, including SARS – CoV and MERS, may not be relevant if SARS – CoV – 2 is more virulent. Many people, including some market participants, appear to have been surprised by the speed at which COVID – 19 has spread across the globe, and significant flight to quality has ensued.
Medical professionals are tracking the spread of COVID – 19 very closely and we have early estimates of the mortality rate. According to the WHO, the death rate from COVID – 19 was 3.14% of infected individuals as of March 3, 2020. This estimate compares to the WHO’s initial estimate of 2% of infected individuals as of February 10, 2020 and less than 1% for the seasonal flu. As of March 15, 2020, the WHO reports that the number of infected individuals was 153,523 worldwide and the number of deaths was 5,736 (3.74%).
The rate of infection from SARS – CoV - 2 is much less clear. According to health experts, many people—perhaps most—who become infected display only mild symptoms. In the United States, the current focus is to slow the rate of infection by social distancing (e.g., preventing large aggregations of people) in order not to overwhelm the nation’s healthcare facilities.
The markets appear to be reacting as if prior experience with viral outbreaks does not describe what could happen with COVID – 19.
Second, the market’s behavior suggests that it anticipates “unknown unknowns” which means that it does not see risk (or quantifiable uncertainty) but rather uncertainty outside of the bounds of experience. Specifically, we see a spike in the VIX Index that matches the spike following the failure of Lehman Brothers in 2008 (the VIX reached 83.3 in intra-day trading on March 16, 2020; not shown in Figure 2). In that earlier period, market participants were unsure how far the mortgage market would sink. The threat to the global banking system seemed great due to the enormous increase in mortgage defaults. There was genuine concern that the global financial system would suffer catastrophic failure.
The current market is dominated by extreme flight to quality, including significant drops in equity prices and Treasury bond yields. On March 16, 2020, for example, the S&P 500 fell by nearly 12% and the yield on the 10-year Treasury dropped 18 basis points to 0.76%.
In particular, the markets appear not to be able to ascertain how significant will be the impact of the virus on global economic growth. At this writing (March 16, 2020), estimates of that impact range widely, though all are negative. Given that the consensus that the pandemic will slow economic growth, perhaps considerably, a sell-off in equities is to be expected. Whether the extreme sell-off we are witnessing as I write is warranted remains to be seen.
Conclusion
Recently, Peter Schiff, the CEO of Euro Pacific Capital, is reported to have said the following of the SARS – CoV – 2 outbreak:
“This is the beginning of the greatest financial crisis in US history. The financial crisis of US of 2008 will pale in comparison as with the severity of this recession. We are going to have a much greater recession than the one that we had in 2008.”
I don’t agree, because financial crises typically are the center of changing human psychology in which people experience disaster myopia followed by disaster magnification. Disaster myopia occurs when people become complacent toward the possibility of an adverse shock, especially if that shock has a low probability and if a long time has passed since a similar shock has occurred. Disaster magnification occurs after a shock to the system and people are forced out of their complacency. The pendulum of psychology swings in the opposite direction so that people begin to see conditions as much worse than they are if measured objectively.
I suspect that, with Knightian uncertainty present in in the global financial markets, investors may be subject to disaster magnification.
No way to be certain, of course, and perhaps the best strategy is to sit tight.
Regardless, we will see…
(1) https://www.cdc.gov/coronavirus/2019-nCoV/summary.html (accessed 6 March 2020).
(2) https://www.ncbi.nlm.nih.gov/pubmed/15018127 (accessed March 16, 2020).
(3) https://www.who.int/emergencies/mers-cov/en/ (accessed March 16, 2020).
(4) Knight, Frank H., Risk, Risk, Uncertainty, and Profit (Boston MA: Hart, Schaffner and Marx; Houghton Mifflin, 1921).
https://www.rt.com/business/483006-greatest-financial-crisis-us-history (accessed March 14, 2020)