Trading a Market Panicked by the China Virus

Panic is a strange emotion.  We can have extreme reactions to minor events if our minds blow those up into catastrophes.  We can also go into denial about genuine threats.  Panicky markets create opportunity, as good assets are dumped alongside the not-so-good ones.  What we don’t know is whether panic is justified.  As the saying goes, if you can keep your head about you when everyone else is losing theirs, perhaps you’re not aware of the situation!
The current situation with the coronavirus in China is a great example of a fear-filled scenario, as uncertainty is built into the situation and the possibility of a horrendous outcome is present.  Here are a few observations that may be helpful for traders adjusting to markets quite different from what we’ve seen so far this year:
*  Volatility and Correlation – This is a different market regime.  Volume and volatility are greatly increased and correlations among markets will be higher than recently has been the case.  When markets are more volatile, the price movement is sizing up positions for you:  risk and reward are much higher for a given position.  Adjusting sizing of positions to account for this change is essential.  Adjusting existing hedges to positions may also be important, given shifts in correlations.  For investors, portfolios that looked invincible a week or so ago (think stocks and high-yield bonds) may suddenly seem quite vulnerable.
*  Following the Story Closely – I’m watching to see if the virus story gains significant traction in the media outside Asia.  I have concerns.  One data point:  if you go online and try to order surgical respirator masks, you’ll see a lot of sites and retailers that are sold out.  Another data point:  China is treating this as a genuine emergency.  You don’t lock down tens of millions of people and build a new, large hospital for nothing.  Still another data point:  Wuhan, the epicenter of the viral outbreak, is also the location for China’s only bio-lab designed to study BSL-4 level pathogens.  Concerns about the safety of the lab were voiced as early as 2017.  And I’m not sure we’ll ever know whether that lab has been involved in the design and manufacturing of bio-weapons.  Bottom line:  when the country closest to the situation is reacting the strongest, that situation has to be taken seriously, especially given the mathematics of viral contagions.
*  Thinking Through Broad Market Impacts – Increases in volatility measures; flight to safe assets; and a new reason for central banks to stick with low rate policies are some expectable impacts.  To the degree that this hampers growth in China, we can also expect some re-rating of global growth estimates.  If we thought tariffs could slow China, this could have a far greater impact on the economic activity of Chinese citizens and companies doing business in China.  Recall how Asian crises impacted the equity markets in the late 1990s.  That didn’t stop markets from rising to major highs by early 2000, but that rise was punctuated by sharp declines and increased volatility.  I’m watching equity prices in China especially closely.  Note that we broke out to new highs earlier in the year and now have returned to the prior trading range in FXI.  Tough to imagine a roaring global bull market and China not participating.  Even tougher to imagine should contagion meaningfully spread beyond China.
*  Timing is Everything – Money managers who are paid on annual performance had started 2020 nicely in the green with the bull market in stocks and handsome returns from risk parity strategies.  Are they really going to want to go red on the year and face investors already wondering why they don’t just invest passively in low-cost ETFs?  Just as we saw quite an unwind in January, 2018 following great strength, a similar dynamic may be at work at present.  Everyone goes for exits at the same time when payouts are at risk.  That created opportunity later in 2018, but it was not a one and done day or two of weakness either.
*  Sometimes This Time Really *Is* Different – I recently wrote about the value of historical market analyses and how those can illuminate current market scenarios.  I also noted how, historically, very strong equity markets tend to be followed by strength in the bigger picture.  Market history is probably the best guide we have to an uncertain future, but idiosyncratic influences can make the present quite different from the past.  Blindly following the past can be dangerous for traders when they face unique situations such as the September, 2001 attack.
If history plays out, the current situation could lead to a great investment opportunity, such as those corrections in the late 1990s, but could also last longer–and can be deeper–than investors can tolerate in the short run.  The one thing we know is that we are facing a more uncertain global landscape, and that will likely be reflected in volatility and increased herd behavior.
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