Financial Markets: no fear of fear

Are movements on stock markets justified by the movements of dividends? No, according to the Robert Shiller, Nobel Prize winner in Economics, who maintains that it’s the combined actions of investors which create ‘excessive volatility.’ The fluctuations that are typical of share prices are far amplified than those of dividends, revenues, and the GDP, even factoring in the normal variability of interest rates and risk premiums. It’s never easy to ascertain the existence of excessive volatility, because we rarely have the chance to carry out controlled experiments; more often than not we don’t know exactly what moves the markets. But the price trends in February of this year in the week from Monday 24 to Friday 28 have a clear and unmistakable driver: the sudden concerns, fueled over the previous weekend (22-23 February), about the spread of the coronavirus in Italy. An unexpected event, at least for the market.

The Borsa Italiana index closed on Monday 24 February down 5.5% after dipping lower than 6%. Two days of volatility followed; then heavy losses were again recorded on Thursday 27 due to international concerns about the global proliferation of the virus. It’s true that at the same time word began to spread of a possible stop to contagion in China. But the credibility of data from that country has eroded to some extent, and no one knows whether in reality the drop in the number of cases is linked to the Chinese government’s clamp down on information.

The Borsa Italiana lost about 60 billion euro in capitalization in a week, translating into an estimated GDP loss which could run between 3 and 10 billion euro. But let’s resist the temptation to label market reaction as excessive or irrational, and try to reflect instead on other possible explanations.

One is that investors are afraid that the GDP will shrink much more than projected by the Banca d’Italia and other research centers. But in this case too, it’s hard to imagine that Italy’s GDP could plummet so far as to justify the week-long nosedive, despite the negative repercussions from a downturn in economic activity and major fallout we can expect for tourism.

A second explanation is that the market was overvalued before the news of the virus broke, so the events of the week in question constituted a correction. We can’t dismiss this line of reasoning for various stock markets around the world, but it doesn’t hold water in Italy. Here market capitalization is much lower than in other countries, and the stock market has had a negative yield for the past 20 years, far below the international long-term average. Much can be said about the Borsa Italiana, but not that it’s overvalued.

The third explanation takes into account the explosion of uncertainty, a phenomenon which goes beyond simple risk and leaves us with no way to formulate scenarios or calculate probabilities. And coronavirus is positively rife with uncertainty. We don’t know exactly what will have to happen so that we can get back to business as usual, even in the areas outside the primary outbreak zones (which, incidentally, collectively generate half of Italy’s GDP). Of course, we can expect more clarity in the coming weeks on the overall situation. What’s more, we don’t know how long it will take before we can be vaccinated against the virus, even though we’ll presumably see results more quickly than in the past, thanks to advances in medical research. And we don’t know if the virus will spread in the US, forcing activity in that country to come to a halt, with drastic ripple effects on the international economy. But as far as the quality of healthcare systems, it’s hard to imagine that America’s is worse than China’s.

Investors with a short-term time horizon tend to sell risky assets when uncertainty is on the rise, to avoid penalizing performance over the coming days and weeks. Long-term investors on the other hand see volatility as a buying opportunity, reaping the benefits of equity premiums. Looking ahead to the next few decades, it seems that more serious troubles than influenza are looming on the horizon, like problems relating to climate change. But there are also many opportunities arising from technological progress.

In dealing with a new and potentially fatal virus, every one of us can adopt different behavior, and change our lifestyle to eliminate the risk by self-isolating in our homes. And the same applies to equity investments. Investors who rush to sell in hard times limit their losses, but probably should never have played the market in the first place. But investors with a long-term outlook can’t let themselves become infected by fear. They have to remember that in every challenge lies the potential for a great opportunity.