Equity market investors have gone through a contrasting range of emotions since the start of the year. The high volatility so far in 2020 can be best explained by behavioural finance, i.e. the study of investor psychology. This field has garnered significant attention since the development of the prospect theory by two psychologists, Daniel Kahneman and Amos Tversky.
Prospect theory, introduced in 1979 and developed further in 1992, describes how investors behave when faced with choices that involve risk. They argue that investors make decisions based on their expectation of gains or loss and conclude that investors are generally loss-averse rather than risk-averse. However, this loss aversion seems to disappear when markets are at the other extreme; when markets are rallying, investors fear missing out on the gains, ignoring any warnings of extreme valuations.
Away from the theory behind behavioural finance, the market moves so far in 2020 provides a perfect real-life example of how investor decision making changes despite little to no change in fundamentals. We shall divide 2020 into three phases: Phase One – Complacency (January to First week of February), Phase Two – Fear (Mid-February to roughly the third week of March), Phase Three – Greed (April and May).
We started 2020 on the back of solid gains during 2019. The S&P 500 (‘SPX’) generated a total return of 31.5 per cent last year as global growth fell to 2.9 per cent in 2019 from 3.6 per cent a year earlier (ironically markets were weak during 2018). This sense of optimism carried into 2020, with the SPX up 4.6 per cent until February 18 as the persistent rally in equity markets led to increased confidence and risk taking. Investors were happy to buy equities despite China, the second largest economy in the world, announcing lockdown measures.
This complacency quickly turned into fear as the first cases were registered outside of China. The risk of the virus spreading outside of China was known, but some assumed that like SARS in 2003, COVID-19 would be contained. Equity markets sold off sharply as it became clear that COVID-19 would become a global pandemic, with the SPX losing 33.8 per cent over a month to March 23. The sell-off was fast and sharp, as the high levels of uncertainty put an end to the longest bull market in history.
The negativity that had taken over investor sentiment in March quickly made way to greed. The SPX generated a total return of 31.5 per cent from March 24 to May 6, making the March drawdown the shortest bear market in history (roughly 33 days). The rally was primarily driven by the sizeable and swift central banks and governments’ response, raising hopes that the economic weakness would be short-lived. Generally, investors required confirmation that the measures announced worked.
Bearing in mind the uncertainty and conflicting news flow, we expect equity markets to move sideways throughout the summer
There was a lag between the Fed announcing measures in 2008 to the equity market bottom in 2009. However, the backdrop has changed significantly since then with central banks becoming a key driver of market action. Investor reliance on central bank support is probably a lot higher today than it was back in 2008.
Equities continued to rally notwithstanding the shocking data published by the big economies during April and May. The global economy came to a standstill, while at the same time unemployment in the US soared, aided by less stringent labour laws. Investors were pricing in a V-shaped recovery, which implies a pickup in the second half of 2020 when compared to the first half. Nevertheless, the lack of any meaningful visibility as well as the risk of a second wave made buying equities a risky proposition, a leap of faith of sorts.
The backdrop of lacklustre economic growth and low rates was supportive for growth stocks. This distorted performance somewhat, as the largest five stocks in terms of market capitalisation on the SPX are: Microsoft, Apple, Amazon, Facebook and Alphabet, generally classified as growth stocks. Therefore, the performance of the SPX has been positively impacted by investor preference for growth stocks rather than a broad-based rally.
Around mid-May, investors started to buy more cyclical and value names as opposed to growth as major economies announced the easing of lockdown measures. For this pro-cyclical rotation to persist, we would need to see significantly better economic data, steepening of the yield curve and higher inflation expectations. The blowout employment numbers published by the US on June 5 was an early indication of this trend but concerns over a second wave put an end to this rotation.
Bearing in mind the uncertainty and conflicting news flow, we expect equity markets to move sideways throughout the summer. We see scope for some of the stocks we follow to outperform over the near term, assuming no change in the virus trends and before the US elections come into investor focus. We continue to believe that despite the extremely high valuations, carefully selected stocks that can generate significant cash flow growth and have a strong balance sheet will outperform in the near term.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
Robert Ducker, Equity Analyst, Curmi and Partners Ltd
As an experienced financial analyst with a deep understanding of the equity markets and behavioral finance, let me shed light on the concepts discussed in the provided article.
Behavioral Finance and Prospect Theory: The article attributes the high volatility in the equity markets to behavioral finance, specifically referring to the prospect theory developed by psychologists Daniel Kahneman and Amos Tversky in 1979. Prospect theory explains how investors make decisions in situations involving risk. It posits that investors are generally loss-averse rather than risk-averse. This loss aversion tends to disappear when markets are rallying, and investors fear missing out on potential gains.
Market Phases in 2020: The author divides the market movements in 2020 into three phases: Complacency (January to early February), Fear (mid-February to the third week of March), and Greed (April and May). These phases reflect shifts in investor sentiment and decision-making as events unfolded.
Impact of COVID-19 on Markets: The COVID-19 pandemic is identified as a significant factor affecting investor behavior. The initial complacency turned into fear as the virus spread globally, leading to a sharp market sell-off. Subsequently, a rapid and substantial response from central banks and governments fueled a quick market rebound, with investors anticipating a short-lived economic weakness.
Central Bank Influence on Markets: The article highlights the changing landscape since the 2008 financial crisis, emphasizing the increased reliance on central bank support in today's markets. The swift response from central banks and governments during the COVID-19 crisis played a crucial role in shaping investor expectations and market dynamics.
Rotation in Stock Preferences: Investor preferences shifted from growth stocks, dominated by large tech companies like Microsoft, Apple, Amazon, Facebook, and Alphabet, to more cyclical and value names in mid-May. This rotation was driven by announcements of easing lockdown measures in major economies. However, concerns over a potential second wave of the virus disrupted this rotation.
Market Outlook and Uncertainty: The article concludes with a cautious outlook, anticipating sideways movement in equity markets throughout the summer due to uncertainty and conflicting news flow. The expectation is that carefully selected stocks with strong fundamentals will outperform in the near term.
In summary, the article provides a comprehensive analysis of the behavioral aspects influencing equity markets in 2020, integrating concepts from behavioral finance, market phases, the impact of COVID-19, central bank influence, and shifts in stock preferences.
