Market behavior reflects how little is knowable

During this period of worldwide crisis, frequent and momentous headlines bring our attention to the short, sharp and unusual movements in the price of all securities, even those of US Treasuries. This can focus our attention on the immediate movements of asset prices. But we should resist the urge to adjust portfolios in response to this. Market behavior reflects how little is knowable. We too must recognize the limitations of our knowledge in times like these. There is no way to position for short-term swings in an erratic global financial market, whose collective wisdom is ‘changing its mind’ frequently. This is the time to look ahead, because history teaches us that when the dust settles the correlations we are accustomed to seeing between asset classes return. At least this is something we can confidently predict. And so in this time of uncertainty, more than ever, we can rely on the long term benefits that diversification brings via a balanced portfolio that is designed for a five year investment horizon.

Uncertainty is part of our daily life. 

We make predictions over short to medium-term timeframes and then take decisions on the basis of those predictions every day of our lives. Weather patterns cannot be predicted with accuracy and yet planes can fly in the sky for up to 19 hours, and we can choose the clothes which we will be comfortable in for the entire day at work, often with some success. Similarly financial market participants predict GDP growth and the likely level of corporate earnings growth with a reasonable degree of confidence. These are the fundamental parameters that underpin equity prices and bond yields. Just like forecasts for the weather, these financial forecasts tend to change relatively slowly. Sometimes there is a shock and we alter our forecasts and adapt to it. For financial markets, shocks can make equities more or less attractive, and when it comes to the weather it may mean we need to sometimes retrieve the clothes we have saved for the next season.

But consider what would happen if an initial forecast for a cool day with a temperature of 21 degrees in Sydney, made at 6 am on the same day, suddenly shifted every 5 minutes such that by 6:30 am the forecast had changed to signal that snow was likely to fall. That would indicate something was wrong with the meteorological tools or that the weather was in a highly unusual state. No planes would fly until some normality returned to the weather forecasting process. Workers would carry with them a variety of clothes to prepare for a range of outcomes in the climate. This sudden change to our lives would also be disconcerting. We might wonder whether Sydney weather, as we have experienced it all our lives, would ever return to normal, and if so when. It is not a stretch to use this fictional situation as an analogy for what the financial community and financial markets have experienced since mid-January.

It was not long after mid-January that the Coronavirus outbreak impacted financial markets, and it was evident from that point in time that it would have some economic consequence. But in the space of just a few weeks the official and private community of economic forecasters around the world have been forced to downgrade their projections for GDP growth very frequently and very significantly. Take the Federal Reserve Bank in the US. The Federal Reserve’s Federal Open Market Committee (FOMC) publishes a set of economic forecasts on a periodical basis and the latest was due to be published soon. But last week Fed Chair Powell informed the public that as the economic outlook hinges on the spread of the virus and the measures taken to contain it, and as this is ‘just not something that’s knowable’, the Fed’s forecasts would not be updated until possibly June. The Australian Federal budget has been delayed for similar reasons.

While uncertainty remains at extreme levels with respect to the spread of the virus and its economic impact, financial markets will remain volatile. 

We have seen correlations rise as a result of the liquidation from all asset classes that has resulted from hyper uncertainty. The lesson to draw from this argues for rather than against diversification, achieved through a balanced portfolio that has the ability to allocate to different industries, regions, currencies, management styles and asset classes. Why? Because it teaches us the limitations of our abilities to forecast over the shorter term. On the other hand, we can be very confident that uncertainty around Covid-19 will be very small in three to five years’ time. And we can also be confident that when the uncertainty falls, correlations between asset classes will too. A well-diversified balanced portfolio can take advantage of this.

Returning to the weather example; it stands to reason that after some stabilization in the degree of adjustments to the weather, airlines would be confident returning planes to the skies, even if it was indeed snowing in Sydney. Also, the realization that the weather can shift so dramatically at times would lead many of us to accumulate a wider range of clothes in our closet long after the shock disappeared. It certainly would not make sense to only have winter clothing and throw out our shorts and singlets. Understanding our limitations in predicting over short time frames argues for more diversification. It is not the outcome – snow or sunny weather – that stops the normal flow of activity. It is the heightened uncertainty. Financial markets will normalize when uncertainty does too, whether the future we face is a bleak one or a more positive one. 

Uncertainty is temporary and so too will be the liquidation of financial assets that it has triggered. 

We all have a resilience, a tensile strength, and over time we can absorb shocks and adjust to them. When more clarity arrives and we are able to more confidently assess the economic damage, then capital will flow appropriately across asset classes, and the price of equities and bonds will once again reflect their fundamentals. For now we remain in a holding pattern. Central banks have injected a degree of certainty to the situation: come what may, we can be assured the monetary policy will remain highly accommodative. This is at least one variable economic agents need not be concerned about when considering whether to apply for a loan or purchase a government bond. Over the long term, the only way to shield portfolios from the unknown is through diversification, as it is the logical outcome of understanding our limitations.