Last week the markets dropped nearly ¾ of a percent due to fear rising from the coronavirus. Why would a virus impact equity markets?
Some people might wonder what a new dangerous virus originating in China might have to do with equity markets. What this tells us whether or not markets are likely to over react to negative news.
As we ended the last decade and began 2020, markets became very optimistic and bond sentiment dropped towards pessimism. Over the past 14 years, this has been a recipe for some market disruption. The reason is simple: as stock investors become overly optimistic, most investors become fully invested in stock, leaving very little money on the sidelines to swoop in and buy short term dips. The result is that any bad news (like the coronoavirus) gives some investors incentive to remove some of the risk from their portfolios. This can exacerbate reactions to negative headlines and make the pain in the markets worse than the raw data would suggest that it “should.”
Below is a chart that shows how excessive optimism became at the beginning of 2020. The stock market tends to over react to bad news when stock optimism is extremely high and that has led to some short term struggles in the markets.
A word of caution is in order: trading on fears like coronavirus could be very risky. Markets can become overly emotional at extremes (over optimism and over pessimism). Even the most seasoned investors must stick to their chosen strategy and resist the urge to get caught up in the emotions of investing.
All strategies need time to work and investment decisions based on fear or greed rarely work out well. There are some unknowns regarding how long this expansion will continue, but markets could boil higher despite over optimistic market outlooks. They do tend to become hyper-reactive to news at extremes and more cautious investors should be aware of that.
While we do not know how this new global issue will play out, we do know that in years immediately following unusually high stock market returns, markets can become over reactive to spots of bad news. It is best to look at more data than just sentiment to determine investment decisions.
Currently, the data doesn’t show a breakdown that is more sinister for stock market investors. This year has already been acknowledged to likely be bumpy along the way, the coronavirus being likely just the first of a few.
It can be hard to ignore the constant overtones of frightening news of deadly disease outbreaks and certainly we should all heed travel warnings and protect our health, but seldom is this something that should cause investors to change course.
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