The Great C^2 and Why The Virus Disaster Struck Markets Swiftly

Quickest S&P 500 Drop Ever:

According to Wikipedia, 3 of the top 20 largest percentage decreases since the 1923 launch of S&P 500 occurred in 2020 spanning March 9 - March 16[1]. These market drops resulted from unprecedented action by governments across many nations to close down schools, restrict travel, limit gatherings, shut down restaurants, and forcing people into quarantine. The actions by our leaders to limit the spread of COVID-19 and protect vulnerable people from danger demonstrate the best side of humanity, as the coordinated effort to hinder a global pandemic is truly a Pareto optimal thought in theory. However, the synchronized action to limit consumption, the largest contributor to GDP, by federal, state and local government is a major balancing act as every additional restriction might force another company to lay off workers or worse bankruptcy and therefore further worsening the global economic crisis. In the movie Wall Street, Michael Douglas character, Gordon Gecko, states the now famous line that “the markets are driven by fear or greed” and the response we see as a result of COVID-19 is fear. The worst of The Great C^2 may therefore not even be the virus itself, but the resulting fear caused by governments not striking a proper balance between action and inaction.

Alanna Shaikh during a Ted Talk.

What is COVID-19?

Before launching straight into the negative impacts a pandemic can have on the economy, we must first explain COVID-19. According to global health expert Alanna Shaikh, COVID-19 is part of a specific set of corona virus that attacks our respiratory system.[2] COVID-19’s genetic material consists of RNA instead of DNA and the virus uses spikes on its surface to invade cells, which is similar to other corona viruses such as SARS and MERS. These spikes are the coronas in the corona virus and COVID-19 is the 7th type of respiratory corona virus known to mankind. According to Alanna, no one as of March 2020 knows the actual mortality rate of COVID-19, but she does mention that 20% of the people that contract the virus might require hospitalization (she did not mention a confidence interval). The biggest difference between for example SARS and COVID-19 is that the former makes people really sick very quickly. This means that people who contract SARS are rushed to the hospital to get treatment, which in turn prevents the spread of SARS itself. COVID-19 might have a lower mortality rate than SARS, but it takes time for the symptoms to develop and COVID-19 is therefore more likely to spread among the population. What makes COVID-19 even more likely to spread is that some young and healthy persons might not even experience symptoms, while most of the people that will need hospitalization are old or individuals with pre-existing conditions. Health professionals worry that if too many people seek medical attention at the same time it will cause a strain on hospitals. As a result, these professionals talk about flattening the curve so that not all people get sick at the same time.

Simple scenario analysis of COVID-19 given various mortality and infection rates.

Sheri Fink writes in a New York Times article that the C.D.C expects that between 2.4-21 million people will require hospitalization in just the United States[3]. In the same article, Sheri writes that the U.S. only has around 925,000 hospital beds, which is clearly not enough to support millions of COVID-19 cases. When hearing this information from Sheri and her journalist colleagues in the MSM, people get scared and fear can then turn into a mass panic. When people are panicking, the market fails to accurately discount the future and the market is therefore unable to establish fair valuations for companies in the global economy.

There have been many pictures showing empty shelves in grocery stores posted on social media. For some reason toilet paper is in high demand amid a crisis.

Positive Feedback Loops

The purpose of the market is to efficiently allocate resources across the globe, which in turn generates fair market valuations. An improved use of resources around the world leads to higher global growth and a higher growth creates increasing market valuations. As a result, market participants in executive positions have a stronger confidence in the economy and will then have their companies invest in R&D and hire workers to create new products and services, which obviously further grows the economy as the goods are consumed. This is an example of a positive feedback loop, but the loop never continues forever as the market has historically moved in cycles. These business cycles are changes in economic activity experienced by economies over certain time periods. One can then draw a conclusion that there must be negative shocks to the system that reverses a positive feedback loop. These negative shocks are either caused by endogenous factors such as regulation and a change in monetary policy or by exogenous factors such as a virus and a natural catastrophe. Both The Dotcom Bubble in 2001 and The Great Recession in 2008 were endogenous crises as the former was caused by excessive speculation on tech stocks and the latter by irresponsible borrowing and speculation on house prices. However, COVID-19 is different from both The Dotcom bubble and The Great Recession as the virus is the textbook definition of an exogenous shock.

COVID-19 interferers with economic growth and the positive feedback loop.

COVID-19's Impact on Consumption

To explain the measures taken to limit the spread of COVID-19, we can use the United States as an example, as the response has been to close down any business that is classified as none-essential. This lockdown strategy by the U.S. government is a path shared by most countries suffering from the virus, but the quarantine’s impact on each economy will differ. The quarantine most likely has a greater impact on consumption economies as these economies rely on sales of goods and services to generate economic growth. According to 2017 data from the World Bank[4], the U.S. is with 13 trillion USD in household final consumption expenditure (HFCE) by far the most consumption centric economy. The large HFCE number accounts for around 68% of U.S. GDP as compared with number 2 and 3, China and Japan, in which the former spends 43% (4.7 trillion) of GDP in HFCE and the latter spends 56% (2.8 trillion) of GDP in HFCE. Based on these GDP numbers, it seems like U.S. may be the country that would relatively hurt the most from an economic perspective by quarantining. The historical 20% valuation drop in Dow Jones, a major U.S. equity index, demonstrates that market participants have discounted a severe impact of the virus on the U.S. economy [5]. Perhaps the market participants are overreacting, as this 20% drop only took 20 days, but below are factors why a financial crisis taking place in the 2020s might be more rapid than previous historical crisis events.

Fear among investors drive market madness.

Three Possible Reasons For Sharp Market Drops

1. Virus Impact Is Easy To Understand:

Unlike other historical crisis events, one does not need a Phd to understand that closing down businesses and restricting movement in response to COVID-19 has an obvious direct economic impact. In 2008, the banking system crashed because complex assets such Mortgage Backed Securities experienced a systematic devaluation as people where unable to finance their mortgages. Understanding leverage and how money from Mrs. Jones’s mortgage payments flow through the system to the banks is difficult unless one has studied advanced courses in finance. As a result, the 2008 crisis spanned over a longer time period, as retail investors were late into the selling game, while more experienced traders were able to protect their assets. The Great Corona Crisis is a crisis easier to understand than the 2008 crisis. However, just because a crisis is easy to understand, it does not mean the crisis is easy to analyze. The impact of COVID-19 is highly uncertain and the first reaction by both professional investors and retail investors has been to sell, which could be a reason for the quickest market drop in history.

2. Trading platforms on smartphones and free of charge equity trades:

With advancements in technology, new ways to trade were invented. Back in the 20th century, investors needed to call up their broker to execute trades. These days, investors do not even need a password to trade equities, ETFs and options. All that is needed is a smart phone with facial recognition software and some leftover cash. What makes it even more attractive to trade in the 21st century is that discount trading platforms in the U.S such as Charles Schwab and Robin Hood charges 0 USD per trade in equities, ETFs and options. The cost of downloading the platform apps and opening accounts is also 0 USD. Combining the fear of a global pandemic with cheap trades and easy access to markets via smartphones is a possible explanation for why markets decreased so rapidly over just 20 days.

3. Global Economic Fragility:

The global economy has become even more global over the past 10 years. U.S. and European companies’ supply chains depend even more on foreign factories in China and other parts of the world when producing goods. Nations not producing components used in more advanced devices can instead focus their comparative advantage on capital and knowledge intensive industries such as professional services. Positive effects then derived from globalization is technological innovation, higher growth, cheaper goods and a greater range of services, but the cost is a more fragile system. For example, a global shock that impact all countries at the same time will make nations focusing on services more dependent on countries that produce life necessary equipment. COVID-19 is the textbook definition of a global shock that impact all countries at the same time and when there is a shortage of ventilators, masks and other medical equipment, import nations such as U.S. are unable to produce the amount of medical equipment needed by hospitals, which makes it difficult for their doctors to treat patients. The inability of doctors to treat patients appropriately then potentially leads to more deaths and that in turn ripples through the economy. If many people pass away and hospitals are continuously overextended, it might force governments to lengthen the quarantine. Ultimately, the ripple caused by the virus creates fear that paralyzes not just a single country, but also a global economy, which explains why markets decreased so quickly.

Some of the ideas listed above are derived from Robert Shiller's excellent book on factors driving Economic Bubbles.

Long term Economic impact of The Great C^2?

As a result of the continuous increase in COVID-19 patients, President Trump has enforced a prolongation of the social distancing rules until at least the end of April 2020. This decision was made after the quickest U.S. bear market drop in history. Without a significant monetary boost from the government, it is possible that restaurants, hotels and airlines will be the first line of industries to default due to travel and social distancing restrictions. When companies default, it also means that lay offs will take place and without work the workers will not obtain a salary. However, a monetary boost is exactly what happened as the central bank and the government has created a 2 trillion dollar financial package, The CARES ACT, which is the largest rescue package in U.S. history. The package is meant to help businesses cover its cost over a four-month period and includes cheap loans to businesses that may be forgiven if they comply with certain preconditions like not firing workers. The package also includes direct help to citizens with payments of 500 USD to adults per child and 1200 USD to taxpayers making below certain thresholds. In February 2020, the U.S. national debt surpassed USD 25 trillion. A higher national debt, all else equal, means larger interest payment to creditors, which in turn increases the probability of default and ultimately lowers the value of the USD. Adding 2 trillion will potentially have a long-term impact on the USD because the only way to get rid of the debt is inflation, but it is impossible to forecast when and the impact of future inflation.

The above image displays a discouraging pattern between domestic debt and war. Under the current global economic system, developed nations are dependent on foreign nations for important components used in production of goods and services. Depending on another country for medicine and important technology infrastructure is a potential national security issue. Perhaps, we will see increased domestic production of certain goods in the future despite increasing prices.

Conclusion

In a global world, countries are more dependent on each other to generate economic growth than previously in history, which is great for humanity as the standard of living has increased for most people in both developing and developed nations. However, globalization has also made the world more vulnerable to systematic shocks as countries are no longer functioning in isolation. COVID-19 is a perfect example of an exogenous systematic shock because it impacts all people in all nations around the world. The virus is really scary as it spreads like wildfire and has a relatively high yet uncertain mortality rate. The infection symptoms can take a long time to develop and for healthy young persons, the symptoms might never show. The virus is a distant cousin to previous mass killing viruses such as MERS and SARS and to limit deaths, the governments across the globe has shut down all nonessential business and forced people to take extraordinary social distancing measures. Forcing businesses to close down and limiting travel have severely impacted the markets and the three largest drops in the S&P 500 occurred spanning March 9-16 2020. The virus will especially impact consumption economies such as the U.S. and perhaps that is why such large drops occurred in the S&P 500. The virus has also caused the quickest equity bear market in U.S. history by falling 20% in just 20 days. The fact that the negative impact of the virus on the economy is easy to understand in combination with globalization and easy access to cheap trading explains why the market took such a severe hit so quickly. The long-term impact is uncertain, but the printing presses at the central bank have never run hotter and we shall see if inflation emerges.

Well done!

//Stayadaptive

[1] https://en.wikipedia.org/wiki/List_of_largest_daily_changes_in_the_S%26P_500_Index [2] https://www.youtube.com/watch?v=Fqw-9yMV0sI [3] https://www.nytimes.com/2020/03/13/us/coronavirus-deaths-estimate.html [4] "Household final consumption expenditure (current US$) | Data". data.worldbank.org. Retrieved 7 April 2018. [5] https://markets.businessinsider.com/news/stocks/dow-index-bear-stock-market-20-days-fastest-history-coronavirus-2020-3-1028989775