Why Did Markets Behave Like COVID Never Happened And Where Do We See Buying Opportunities Now?

InvestSense
Jonathan Ramsay
Jonathan Ramsay
InvestSense Director
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The US equity market recently surpassed the level it was at the beginning of the year when the market hadn’t even thought about COVID. This was surprising in itself and didn't seem to reflect the real damage suffered by economies due to COVID.

Even more perplexing was the fact that the US market representing the worst-hit economy performed the best. Then in the last 2 days, we have seen markets display the kind of falls we haven’t seen since the midst of the crisis. What gives? As usual, it is a case of following the money…



So how could the market have looked through the real effects of a global economic shutdown, the effects of which have been compared with the Great Depression? First of all the reasons for this are not simple as it has the most astute investors in the world, by their own admission, flummoxed. However, there are some smoking guns. 

First of all,  and by far the most important gun is the one fired by the US Federal Reserve - an unprecedented degree of monetary stimulus. Yes, that word is getting used a lot but probably not overused in relation to the actions of central banks and the reactions of markets as the two following graphs show:




Secondly, there are good reasons for markets to be confusing for fundamental investors over the short term. Increasingly they are no longer in the driving seat. Machines and retail investors are becoming increasingly important. 

Consider some interesting market action in the last few days with a number of bankrupt or about to be bankrupt stocks such as Hertz and JC Penney. The Wall Street Journal published a fascinating couple of articles entitled Davey the Day Trader and Individuals Roll the Dice on Stocks as Veterans Fret sheds some light on the pointy end of this phenomenon. These articles sit behind a firewall but the following quote from a 22-year-old from Kentucky about what she did with her stimulus check from the government gives you the gist  “It was basically free money, so, you know, I decided to play around with it,” she said. “You might lose some, you might win some. It’s like a gambling game.”  Who would have thought that stocks in or approaching bankruptcy (where it is highly likely that equity investors will lose all their money) would become the gambling outlet for cashed-up millennials? Yet this appears to be what is happening and the chart below is a neat example of how retail investors can get themselves into trouble writ large (or very small depending on your vantage point). By comparing the rise and subsequent fall of several hundred percent of both these bankrupt stocks with the volume in the panel below you get a keen sense of how retail investors can get ‘rinsed’ by the market.



More generally we are seeing the result of what one fund manager we spoke to recently called ‘the buy on the dip generation’ where even many young professional investors have been conditioned in an era where central banks will reliably and increasingly aggressively underwrite markets. It is also the tip of an iceberg that leads down to the whole concept of passive investing. In theory, passive investing is a force for good in forcing down fees as long as you still care about the fundamentals of what you are investing in. An increasingly large cohort of passive ETF investors do not and this is in our view creating distortions and, we hope, opportunities under the surface.

So what are we doing about it?


While we can interpret the strong gyrations of markets by following the money and these liquidity and asset flows are undoubtedly influential in the short-term, they can, by definition, only be ‘followed’ in hindsight. To look forward we still need to rely on valuation which works fairly well in the long term but, for the reasons outlined above, not so well in the short-term. Then we just wait for the long-term to become the short term as time passes. For that reason, we have spent the last few weeks sifting through what has perhaps been left behind and ignored by the ‘hot money’ and still represents decent value and acceptable long-term returns. These areas include Asia ex-Japan, smaller less well-known companies and ones that are favoured by very out of favour value managers. 

The latest pullback is starting to give us a better buying opportunity and you will see some new names in portfolios over the next few days and weeks. If that sounds a bit like we are joining the ‘buy on the dip generation’ then there is some truth in that but we would rather do that on the dip than the peak and the important difference is that we are buying very different things.

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