The first real crisis for post COVID investors

A conventional crisis, finally

Markets have known to react to events and price securities based on perceived risk and the resultant discount or premium to their fair value. This being the norm, the concept of fair value appears dubious since most market traded securities rarely ever trade at their fair values. They retreat far in discount to their fair value in moments of extreme fear and heightened risk perception and move up in euphoric times far above their reasonable estimate of fair value. However, markets are not always at extremes of these at all times and trade within a range of relative overvaluation or relative undervaluation for most of the time. This being the reality any prognostication on market valuation is bound to fail since most analysts will price securities on known or estimated cash flows and work out a scientific price. As we have described it in the preceding few sentences markets rarely ever trade at such values. So how do we view investments given this backdrop?

What do investors seek?

Investors deploy capital in the financial markets and expect a reasonable return for the same over a period. These returns vary by instrument, term, volatility and relative safety. Over time certain averages emerge for returns given the term in which the investor deploys the capital and certain hurdle rates appear on the horizon.

Investments 101

Fixed income instruments provide a fixed return to the investor based on coupon rates and market yields for stated maturity periods. And the market variations or “risks”, here, are on the eventual return of capital (credit risk) and variability in interest rates (volatility in bond prices of market traded bonds). They average a few hundred basis points above the “risk free rate” of return in government securities of that country or some such base rate.

Investors desiring a higher return than available in fixed income instruments venture in equity or equity related instruments that, for a significantly higher volatility, may provide higher return potential over a longer period for time. Ownership of listed equities have demonstrated higher returns over fixed income returns in almost every market in the world. A combination of these or some other hybrid instruments including derivates and hybrid instruments largely completes the investible universe, subject to exotic investment avenues such as hedge funds, private equity and others.

Do global events and crisis change this understanding?

The essential nature of modern capital markets over the past 80-90 years have demonstrated that this remains true over the longer term no matter what crisis the world undergoes. Since the Great Depression in the 1930’s a long period of returns data is available to showcase the reliability of this claim in almost every market. However individual portfolio returns deviate significantly than market returns over such a long period of time and hence market returns of securities should be judged against investor behavior, liquidity needs and idiosyncratic risks in individual companies and market related events. This is the most fundamental concept that most investors ignore, particularly at inflection points.

What is the nature of the current crisis?

A supply shock that is more conventional than more recent events

• The Global Financial Crisis (2009) originated in the sub-prime mortgage markets of the US and eventually plunged the entire global markets into a tailspin rendering many bankruptcies and a need to bail out large financial institutions by local governments. While this rendered the entire capital markets illiquid for a considerable period, all markets eventually recovered over a relatively short period of time thereafter

• The COVID pandemic (2019) plunged the world into a state of inactivity where global growth dissipated completely, and this too had a global impact on markets worldwide. Within a year markets were up and crossed all-time highs in a post COVID demand recovery period

• In 2022 Russia and Ukraine entered armed confrontation that threatened to disrupt global growth and markets responded negatively again as Russia was sanctioned by most western nations and its ability to sell crude oil was seriously questioned. All markets reacted to the event and even at that time the fear that this prolonging of war could lead to a wider conflict with NATO nations and eventual weakening of global growth

• The current crisis involving the US and Iran threatens markets in a similar fashion and true to form the markets have reacted predictably downward. It is essentially a more conventional crisis that points to supply disruption in the energy markets, possibly leading to inflation and in turn higher interest rates and the usual economic impact on global GDP growth and vulnerabilities for corporate profits in manufacturing firms. The crisis is especially worrisome for countries that depend on imported crude for domestic consumption.

If we notice the pattern a few points emerge:

1. The longer-term averages of asset classes did not change over this period.

2. Investors who reacted to each event did not participate in the eventual recovery and outsized returns of the period immediately following the crisis period

3. Hence individual return metrics are significantly different for most investors and probably lower than averages

The first real test for post COVID Investors

New investors who led the post COVID entry into stock markets with increased conviction and confidence are facing the first real challenge to their understanding and strategy. Significant numbers of small investors opened demat accounts and started dealing in direct equity over managed portfolios and worse, have ventured into derivatives and highly leveraged positions thinking markets always go up. They do, but in the long term.

It will now be a test of character and fortitude to take lessons from history, analyze their individual goals, re-assess their risk tolerance and act sensibly. Easier said than done!

Happy investing!