Author: Christopher P. Hendrix, CMT Page 1 of 10

Measuring Fear: A logical assessment of COVID-19 and its effects on the financial markets

Blogs about the coronavirus are dominating digital media and for good reason.  The virus is clearly impacting us at a quickening pace.  A clear impact is fear.  Case numbers and death tolls are shown on television and internet news seemingly all throughout the day.  Fear manifests itself in many ways.  Early signs have been through decreased travel, primarily air flight and cruise ships.  We are starting to see public gatherings such as sporting events being canceled or modified.

Fear, no matter what the source, plays an important role in the financial markets.

As we step back and gather clues, a logical path would be to look at what the financial markets did during prior times when there were threats of a worldwide pandemic.

Over the last few weeks, I have seen information like this in table and chart form (see below).  This information may give some degree of comfort, implying the historical tendency suggests very high odds of a gain in the intermediate term.  But what about the time in between day 0 and the six months out?

Markets have experienced unprecedented movements that have not been seen but just a few times in the last 100 years.  Is it logical to embrace the indication from a table or similar statistics of prior outbreaks?

Not just quantify it but to gauge its movement. The point is to move beyond interpretation of headlines and to focus more on interpreting human behavior.

A relatively recent period of a sharp decline from new highs was Q3 2018, followed by the rebound in Q1 2019.  Sure, this is not related to a previous virus, but the example shows a moving gauge of fear.  The VIX Index is commonly called the “Fear Index” for good reason.  In the chart below, the VIX itself is not displayed, but rather, a momentum indicator of the VIX. A momentum indicator measures the speed of price changes. Measuring the momentum (or speed of price change) of the VIX allows us to track that acceleration or deceleration of fear.  Even with the VIX smoothed by the indicator, it still has some gyrations.  If we follow the general direction and the overall zones, such as Fear Dominant or Calm Dominant, then we can get a better handle on the connection to the movement in the stock market.

Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved

From May to October 2018, the Momentum of VIX was dominated by calm, allowing for the S&P 500 to trend higher.  Naturally, fear crept higher as the rally became older.  In early October, the Momentum of VIX moved out of the middle neutral zone and into the Fear Dominant Zone. At that moment in October, I’m sure some questions were asked that are being asked today such as, “What about precedents?” And, “How long should this last?”

The bottom-line question for today is, “How long is the crisis going to last?” and that question may have two basic answers.

The first may be related to the headlines and the second related to the stock market sell-off.  The two are not necessarily tied together.  Headlines may still be scary to the public but if some underlying forces are changing investor perceptions, then the stock market has a higher probability of improving.  In the chart above, the sharp drop in the Momentum of VIX at the very beginning of 2019 was enough to cause it to reach the Calm Dominant zone.  If the charts and tables in October 2018 stated the market would be higher six months later, then, yes, they would have been right.  However, this example shows the ongoing warning of the selling pressure for several months until the climate of fear changed.

Earlier this week I started to have a few body aches and a low-grade fever, both very minor.  Regrettably, I went into the office before sunup to get some work done, thinking I’ll go home if my condition worsened.  As people came into the office and became aware of my condition, the growing fear was palpable.  I was urged to go to the doctor, but to call first.  I called a well-known walk-in clinic but was told they were not prepared to test for Covid19 and was instructed to go to the emergency room.  I did and was given a screening tests, including a chest x-ray by medical personnel in full protective body suits.  I learned the hospital reports the findings to the local health department and then to the Center for Disease Control (CDC) for further instruction – to administer a rare Covid19 test or not.  Fortunately, it was determined I have a more common flu strain.  That said, I am writing this blog from quarantine – a self-quarantine but one advised by the doctors.  In the days since the emergency room visit, news on a local and federal level has intensified to where grocery shelves are being emptied even for seemingly random items.  I am seeing firsthand how the fear related to the headlines may get worse before getting better, but as a financial professional, I am monitoring the change in fear to get a better gauge on the impact to the financial markets.

Factor Investing

The stock market is often referred to as a single entity but is made up of many moving parts.  Looking beneath the surface at single and multi-factor indexes can help investors better understand trends that may not be as visible when looking at the major indexes.

Factor investing has been around for many years but has only become more mainstream recently as investors have been given easier access to more specialized investments.  This area has been evolving with the growing popularity of “multi-factor” investments.  First, let’s begin with defining single factor investments and then progress onto more complex multi factor methods.

Single Factor

People tend to gravitate toward organization and categorizing information in order to better understand attributes and possible outcomes.  As an example, consider this analogy between factor investing and cars. Cars with big V-8 engines tend to be fast and powerful while those with small four cylinders tend to be more fuel efficient and less performance oriented.  Such a conclusion may not always be the case but is a tendency.  Engine size is simply one “factor” when assessing an automobile.  Investors do this with stocks too.  The most widely recognized indexes are one factor, or “single factor”.  A single factor may also be characterized by a sector such as a semiconductor index or a gold stock index.

The S&P 500 Index may be diversified but it is simply the 500 largest companies.  This makes size or market capitalization the single factor.  Along the same lines, the Russell 2000 Index is a small-cap index.  In the chart below, there was a clear distinction between the performance of large caps versus small-caps during mid-2018 as small-caps led the way higher.  In 2019, large-cap stocks have been displaying overall leadership.  This illustrates how factors can help explain what has been driving returns, giving a deeper perspective than over generalizing movements in the stock market.  Investment choices have become more easily available to investors that attempt to give exposure to those factors.

Multi-Factor

Multi-factor investments are the natural progression after single factor ones.  Common multi-factors include value and growth.  At first glance, these individually may sound like single factors but to determine value or growth, many factors are combined.  For example, an index provider putting together a value or a growth index may use price-to-earnings ratios, price-to-book, or dividend yield among other criteria.  These are most often well-defined, quantifiable filters to find stocks to be included in the index.

If some of the factors already covered are combined, the stock market can be broken down to an even more granular level often called “style investing”.  Each size, small, mid, and large cap is then further separated into growth or value.  In the chart below large-cap value is being compared to small-cap growth.  During the first three quarters of 2018, value stocks were rather subdued while small-cap growth was rewarded.

Factor investing has adopted very specific characteristics beyond the historically common size or styles.  Categorizing stocks down to attributes can yield an interesting perspective.  Some examples are high and low volatility, value, momentum, and quality.  These tend to be multi-factor as it can take a combination of numerous filters to find stocks with the targeted characteristic.

A momentum factor index or investment may use the performance return of multiple time frames and may be absolute returns, or the stocks return, relative to a benchmark. Some index companies define momentum as positive earnings momentum (growth factor). Quality factor investments may include formulas that filter for companies with low debt, stable earnings growth, and measures of profitability.  The recipe for making a multi-factor index it generally transparent and can be found in documentation released by the indexing company.

Having factor-based investment choices allows investors to be positioned to possibly take advantage of various economic or technical conditions.

  • Quality and lower volatility factors may take on defensive characteristics during times of stress in the markets.
  • Momentum and higher beta factors may take advantage of bull market rallies when higher risk is being rewarded.

Active portfolio managers may use rotation methods, moving between various factor investments as conditions change.  In the chart below, the black lined Relative Strength, displays the performance of the high beta factor to the low volatility factor.  A rising black line conveys leadership by the high beta index and a falling line shows leadership period by the lower volatility index.  Technical analysis methods can be applied to the Relative Strength line in order to better define the trend of leadership and its transitions.

Uncovering the idiosyncrasies of the stock and bond market in order to invest strategically has always been an obsessive compassion of the portfolio management team at Spectrum Financial. The team uses several disciplines and factors when constructing portfolios and making investment decisions for its clients.

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Spectrum Financial, Inc 2020