This Too Shall Pass

March 2020
Read Time: 10 min

Investors are facing unprecedented market volatility as the coronavirus pandemic creates severe economic dislocation. To help understand the turbulence, moving beyond the short-term noise, Rob Arnott, the founder and chairman of Research Affiliates, answers questions posed by Jonathan Treussard, a partner and senior member of the executive team, about how investors should manage the potential risks and opportunities that emerge.

Jonathan Treussard: Rob, can you put the current market turbulence into perspective? How unusual are these market movements?

Rob Arnott: The market is responding to a risk unlike any we’ve dealt with in recent decades. This crisis is not 9/11, though it may feel like we’re under attack. And this crisis is not 2008, although our financial markets entered 2020 with substantial cracks and weaknesses.  While days like yesterday [March 16] (and a few before that) aren’t common, they come around with sufficient frequency that I’ve seen a few before: October 1987, 9/11, and, of course, the most volatile days of the global financial crisis all come to mind. But whereas I’ve seen market and economic crises over the four decades I have been in this business, this crisis is evolving faster than any in my lifetime.

Jonathan: Given the extremely rapid pace of this crisis, the natural next question is: Is there more pain coming?

Rob: Although the tendency is to try to forecast the future, nowcasting is a real danger. This crisis is evolving too rapidly. Nowcasting can lead us astray because events are still unfolding. Today’s numbers will quickly become quaint as the number of cases of COVID-19 rises around the world. Today’s “now” is the tip of the iceberg—so don’t get anchored to it. Later, after a period of serious challenges, we will begin to see progress, and the economy will eventually emerge from this nuclear winter, though there will be sector impairments, bankruptcies, and so on. As always, the time to buy is when we’re at “peak fear.”

Jonathan: When do you expect we will reach “peak fear” and what can we learn from the past?

Rob: Stocks will begin to recover long before the pandemic is on the wane. The strongest bull markets are not built on a foundation of good news, but on diminishing bad news.  Wouldn’t it be nice if the world of academic finance had coined the expression “equity fear premium” instead of “equity risk premium”?! That premium is at its best when fear is at a peak. It will be hard to be perfectly right on the turning point, naturally, but don’t wait for the good news—just wait until the pattern of bad news lets up.

Jonathan: Where are expected returns now, in light of recent market moves?

Rob: We began the year with US stocks showing an estimated real return of zero over the decade ahead. That zero comes in the form of bull and bear markets along a flat trend, much like we saw in the 2000s. A bear market, if it’s not a result of the economy being dismantled, increases the risk premium and boosts forward-looking returns. A simple back-of-the-envelope analysis would suggest that the zero real return we were expecting two months ago is now 1% to 2% higher. Still not a brilliant return, but way better than it’s been in years.

Jonathan: What do you mean by “if it’s not … the economy being dismantled?”

Rob: Whether by choice or by fiat, we’re not using planes and restaurants as we did only a few weeks ago. Many businesses will go bust. But roll the clock forward five years and the many surviving businesses will be faring well, some with fewer competitors, and on top of that, some industries will have fewer zombie companies.

Jonathan: Some in the industry could conclude this is a time to invest in the FANMAG stocks and to sell value and emerging markets. What do you say to them?

Rob: The punditry points out that Google and Facebook don’t depend on supply chains out of China as evidence that we should continue to chase the FANMAGs and shun value. Really? Google and Facebook are advertisers first and foremost. Will advertising budgets be increased or decreased in the months ahead? The punditry likewise points out that emerging markets (EM) don’t have particularly good health systems and are likely to be hit hard by the novel coronavirus. Pardon me, but don’t we (and Japan and Europe) have further to fall, economically, than EM economies, particularly in terms of valuations?

Jonathan: Any closing thoughts?

Rob: Just a few weeks ago, you and I wrote an article on nowcasting. What is nowcasting?  It’s providing a cogent, well-reasoned explanation of what’s already happened, expressed as a forecast of the future. 99% of what we’re hearing about the impact of COVID-19 on the macroeconomy and capital markets is nowcasting. BEWARE!

A lot of bad news is coming at us, with some dangerous times ahead, but as fear peaks in the weeks to come, the time will also come when bargains make themselves obvious to the naked eye of the disciplined investor. The window of opportunity as always will be short, but highly rewarding over the longer term.

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