Laypeople usually assume that stock markets crash after natural or political disasters (such as wars or epidemics) and recover once their consequences are dealt with. However, in practice the markets react in more complicated and counterintuitive ways. Some of the bloodiest wars of the 20th century only put the pressure on the markets at first, while later the trend reversed and the markets started growing disproportionately fast. According to the usual pattern, the markets crash during periods of high uncertainty rather than the worst part of the actual crisis. When the uncertainty is largely gone, the investors’ optimism can return nearly to its pre-crisis levels, even in an otherwise critical situation.
When trying to predict the trends of the ongoing crisis, we should consider how similar events influenced the markets in the past. However, the current pandemic is unprecedented in many ways. Its closest equivalent was the 1918-1922 Spanish flu pandemic – however, it began during World War I, and therefore its influence is hard to separate from that of the war itself and the postwar recovery. Other disasters, such as the wars themselves, hurricanes, terrorist acts, and other events have their own distinct features that make them different from epidemics. Wars are usually more predictable, while hurricanes last only a short amount of time. There is, however, one thing in common for them all.
Corsair Capital, the event-driven long-short equity hedge fund, gained 6.6% net during the second quarter, bringing its year-to-date performance to 17.5%. Q2 2021 hedge fund letters, conferences and more According to a copy of the hedge fund's second-quarter letter to investors, a copy of which of ValueWalk has been able to review, the largest contributor Read More
Uncertainty is the Central Factor for Crashes and Recoveries
History has shown us that crashes are usually quick and only last as long as there is a lot of uncertainty. If, however, certainty increases, then the markets recover rapidly, even if the disaster or the war is still going on. There are several factors that stimulate optimism in the market's participants. They could be broken down into rational factors (ones that can help one maximize one's profits in the most efficient way) and irrational factors that stem purely from emotions.
The key rational factors are currency inflation (that requires one to convert their cash to other assets as quickly as possible) and competition between investors, as they try to find the bottom before the recovery and make maximum profits off the crash. Investors are always afraid of falling behind and look for the slightest reasons for optimism. Even if the mass buying of assets begins with only a small fraction of investors, others would join them quickly, as asset prices are going to skyrocket on the next day.
The key irrational factor is the public's weariness with pessimism, which makes them prone to exaggerate the impact of the positive factors. Pessimism is directly linked to uncertainty and the fear of the future. If the situation is difficult but predictable, it is easier to bear.
Let us examine a few historical examples and find parallels between them and COVID-19.
Are Wars Beneficial to the Stock Market?
Wars are an obvious example of the discrepancy between the actual disaster and the market's reaction to it. Let us discuss the two largest wars of the 20th century.
Just as World War I began in mid-1914, the American stock exchanges closed due to the fear that the Europeans were going to sell off all of their assets. The trading resumed in December 1914 with the Dow Jones index quickly dropping by 24%, but recovering just as quickly afterwards. By the spring of 1915, the index regained its prewar standing, even though the war was far from being over. The aftermath of the war and the postwar period saw a colossal 6-fold increase for the index.
The start of World War II in 1939 led to an even smaller crash – the index only dropped by around 10% before recovering later that year. However, when the US entered the war in 1941, it caused a sharp 40% drop, with the bottom being hit in 1942, and the full recovery happened by mid-1943. In 1946 Dow Jones surpassed its prewar level by 35%, and 1949 saw the beginning of a rally that lasted until 1966 and again resulted in the index increasing 6-fold over its prewar level.
It is possible that the American market behaved in such a way because the country was located far away from most fronts. However, if we examine the situation on the Berlin Stock Exchange in Nazi Germany, we would see that its market cap increased fourfold from 1932 to 1943. The key events of this period, including the invasion of Poland and the USSR, did not break this pattern, as the investors in the aggressor country regarded the escalation of the war with optimism, up to the Battle of Stalingrad. Then Germany's prospects in the war became much worse, trading was restricted, and the price quotes for the key companies were effectively fixed.
Terrorist Acts and Natural Disasters
Natural disasters typically have much less influence on the markets than wars. They are also fundamentally different from epidemics in how they develop in time. After a hurricane or an earthquake, panic lasts no longer than a few hours or days. The period of uncertainty is short, and it is soon followed by the recovery of the losses.
Terrorist acts are more similar to epidemics, as they cause the populace to live in fear of new attacks, as it was after 9/11. But even then the recovery was quick. The S&P index dropped by 10% over 10 days, and 20 days later it regained its position.
Environmental disasters are even more similar to epidemics, as the extent of the damage they cause may not be clear for a long time.
The oil spill at the BP platform in the Gulf of Mexico began in April 2010. The crash did not happen until May, and lasted until early June with several brief recoveries. By the end of the crash the index fell by 17%. The index began to recover in earnest afterwards, even though the oil spill itself continued until September. S&P 500 regained its pre-April level by November. This confirms the pattern we stated earlier: the fall happens during a period of uncertainty. In the first days after the fire at the drilling station the investors did not believe that the problem was going to last as long as it did. However, when it became clear that the spill is not contained yet, more pessimistic outlooks started to appear, as some people assumed that the disaster was going to escalate indefinitely. The longer the spill lasted, the worse the prospects seemed. The indices only started to recover as the efforts to combat the disaster started to bear some fruit. Yet unlike 9/11, the recovery was already complete before the situation became more certain again and the spill was contained.
The S&P drop that followed the Fukushima disaster lasted for 5 days and amounted to 6%. Two weeks later the index recovered. The Japanese index Nikkei 225 experienced a much sharper drop – it fell by 17%, but the drop itself lasted only 4 days. In the next two weeks the the index regained its position by half, and only by August did it manage to recover another quarter of its pre-disaster value. For this entire time, the Japanese were seriously afraid of radioactive contamination spreading to Japan's territory and waters, while for the US the danger was significantly lower.
The Future of the COVID-19 Crisis
The development of the COVID-19 crisis in time has largely confirmed the patterns described above: the sharpest drops happened during the period of highest uncertainty, when neither the effectiveness of the quarantines nor the governments' ability to prop up the economy were clear. The economy started to recover as the situation started to become more certain again, with the Federal Reserve's measures, the decrease in the number of new cases per day in Italy, and the end of the oil war. However, it is still unknown whether the situation hit its final bottom in March, and how much time it will take to recover.
Of all the analogies that were made above, the COVID-19 crisis seems to be closest to the oil spill in the Gulf of Mexico. In both cases the scale of the disaster was unclear for a long time. In addition to that, the S&P index fluctuated wildly with many local minima that could have been mistaken for the bottom. It is likely that many investors miscalculated and purchased as many assets as possible during that false bottom before the real one was reached. Unfortunately, this says little about the ongoing pandemic. Whether the bottom in March was real or not depends on a factor that is yet undefined – how long the quarantines are going to last. Even if they are going to decrease the number of new cases per day, this decrease seems small so far.
The pandemic also has obvious parallels to the world wars, as there are human deaths in many countries, even if the severity of the situation differs per region. A large part of the global economy is being suspended to give way to “wartime” economy (mobilizing medicine and the police) and “postwar” economy (adapting to the world where telecommuting becomes more prevalent and social services play a more significant role than before). And now the stocks of many companies are already growing – not because the investors expect the crisis to end soon, but precisely because the crisis increased the demand for these stocks, and that demand is likely to remain high after the crisis as well.