Dr. StrangeVol, Pt.2: Epidemics, Narratives, and the Market

Go figure: you write one little article about how the VIX is staying surprisingly low given the major events happening around the world, and then the very next trading sees VIX spike and the beginning of one of the largest downturns in the US market since 2008-9. VIX has gone from 17.17 on 2/21 up to 41.94 at market close on 3/6. The S&P 500 is down 11% since 2/21 and over 12% from it's peak on 2/19. Stores are seeing a run on N95 masks, hand sanitizers, toilet paper, and bottled water. Films such as Outbreak and Contagion are trending on streaming services. I could probably sell my (unplayed*) copy of Pandemic Legacy: Season 1 on eBay for a tidy sum right now. COVID-19 is dominating news coverage, and there’s a very real possibility that this virus will deliver on the oft-predicted recession that’s perpetually been right around the corner. But why this virus? There wasn’t a major downturn in the markets when Swine Flu, SARS, Avian Flu, or other viral outbreaks occurred in this century. What makes the coronavirus different? Well, it’s a combination of two things: words and actions.

Behavioral Finance is a trending specialty within the larger field that deals primarily with how public opinion and consensus can drive markets independent of financial rationality. Nobel Laureate and CAPE developer Robert Shiller is s̶t̶a̶t̶-̶p̶a̶d̶d̶i̶n̶g̶ one of the major voices in this newer realm of study, and I’d highly encourage anyone remotely interested to pick up a copy of his book Narrative Economics. The concepts aren’t new; people have been talking about market bubbles for decades, and “hot stocks” like TSLA have been around for even longer. Sentiment or emotion can decouple market performance from “expected” performance, sometimes for a short period, sometimes for much longer, until the market eventually corrects the divergence, sometimes in an abrupt, violent way.

Look to last August, when the yield curve of US Treasury Bonds inverted. Without getting too into the technical mumbo-jumbo, a yield curve inversion typically indicates that the market believes a decline in inflation (ie typically a recession) is going to occur in the near future. A yield curve inversion is 7 for 7 in predicting the previous recessions, so naturally this led to a narrative that the markets were going to decline, leading to a poor performance in US markets in August. However, this narrative was quickly replaced and forgotten, and the end of Q3 and Q4 2019 saw a massive bull run to push the US markets to all-time highs. Ironically, the yield curve inversion predicts the start of a recession occurring in the following 12-18 months, so people who panic sold in August missed out on the bull run, and people who forgot the narrative and didn’t prepare for a possible market downturn are getting hit now. This is what I was referring to earlier about words and actions. The words, ie narrative, around the yield curve inversion were quickly replaced by other news, leading to a short drawdown in August off the back of the news followed by a bounce back as new narratives pushed the yield curve narrative out of public consciousness. Now that the market is declining due to COVID-19, the yield curve narrative is rearing its head again, reminding people that a reliable indicator is stating that a recession will occur soon. Will these two narratives act constructively and fulfill their prophecy? Only time will tell.

The other half of the equation is ‘actions’. There are a myriad of quotations that deal with the dichotomy between actions vs words ("actions speak louder than words”, “talk is cheap”, “speak softly and carry a big stick”, “words are wind”, etc.), but both have their effect on markets. Let’s look at a the words/action effect on a market that dealt with a medical epidemic. The Ebola outbreak in West Africa in 2014 was a huge news story when it happened: Liberia, Sierra Leone, Guinea, Nigeria, and Mali all saw Ebola cases spread across their countries. While Ebola doesn’t transmit nearly as efficiently as the coronavirus, the 40% mortality rate of Ebola versus the ~3% of coronavirus made for an epidemic of a different strain but a similar seriousness. First, let’s look at how Ebola affected the West African markets. I looked at two indices: the BRVM 10 index in Cote d'Ivoire and the MSCI Nigeria Index. MSCI Nigeria covers Nigeria, while the BRVM, or Bourse Régionale des Valeurs Mobilières, is a regional stock exchange that serves the West African countries of Benin, Burkina Faso, Guinea Bissau, Cote d'Ivoire, Mali, Niger, Senegal, and Togo. There’s not a 1:1 overlap with the countries affected by Ebola, but 1) the countries affected by Ebola are difficult to get stock exchange data on, and 2) the BRVM countries are primarily sandwiched between Nigeria, Guinea, and Liberia and therefore would have been dealing with potential spread of Ebola to their countries at the time.

According to Google Trends, the peak of the Ebola virus narrative occurred in October 2014. At the end of September 2014, the BRVM 10 and MSCI Nigeria indices were at drawdowns of 2% and 5%, so both exchanges were doing fairly well despite the Ebola epidemic. However, the narrative broke out in October: over the course of this month, the BRVM 10 saw its drawdown descend to 8% while Nigeria sunk to 16%. Nigeria would see a drawdown all the way to 35% in December 2014 and January 2014, while BRVM dipped down to 11% in mid-November. Clearly there was an immediate effect on these two markets as the narrative took hold; the dips in October correspond with global public consciousness of the situation and the markets reflected this increase in investors’ information set. The story doesn’t stop here, though.

The West Africa Ebola narrative looks to be pretty much done by the end of 2014, but the epidemic would see its end as various points out to 2016, depending on the country. The three countries hardest hit by the epidemic (Liberia, Sierra Leone, and Guinea) wouldn’t see the end of their outbreaks until the first half of 2016. Mali saw its end in January 2015. Nigeria? October…2014. That’s right: the 35% drawdowns in December and January were after the outbreak was over. There was clearly a disconnect between the narrative and the facts of the epidemic. How long did it take for Nigeria’s index to get out of its drawdown? Nigeria would finally see a new high in January 2018, but not before falling to a 50% drawdown in mid-January 2016, well over a year after the epidemic had been contained in the country. BRVM? As of the end of 2018, the BRVM index was sitting at a 51% drawdown, having never recovered from the Ebola narrative.

Why did this occur? I think it comes back to the information set: West Africa is not a region of the world that a lot of news comes out of. In fact, what have you heard about West Africa since the Ebola epidemic? Humans are inherently efficient when it comes to topics that aren’t of interest to them. Because of this, we tend to default to the most-recent events or news about a topic. This would lead many under-informed investors to believe that West Africa was still dealing with Ebola well after the outbreak was over, allowing it be reflected in market performance. Nigeria was able to claw out of that hole, mostly due to it being one of the largest economies in Sub-Saharan Africa and having subsequent additions to its narrative. BRVM, a much smaller region, wouldn’t have as many (or any) changes to its information set in the global consciousness. While Ebola is no longer an issue (well, in West Africa at least), the narrative continues to give Ebola life in market sentiment.

So, what does the Ebola narrative and effect have to do with COVID-19? It demonstrates that there will be two effects on the markets: the narrative effect, and then the actions effect. We’re currently living through the narrative effect, with COVID-19 dominating the news cycle, the VIX spiking on investor fear, and everyone imagining the worst-case scenario as they hoard TP and avoid going out in public**. The narrative will eventually fade…but that doesn’t mean the end of its effect on the markets. In fact, there’s a lot of fallout from this epidemic that has yet to be seen. The downturn in manufacturing output in China due to quarantines will reduce supply across a variety of industries, leading to product scarcity and potentially underperformance in quarterly earnings for the near-term. Travel companies will see a hit due to a decrease in travelers, affecting airlines, amusement parks, hotels, etc. The actions being undertaken right now, outside of the direct view of the narrative, will have long-reaching effects on the market…unless they don’t. A vaccine could alleviate much of the concerns, inspire confidence in the market, and lead to a massive rally that bulldozes through a quarter or two of underperformance.

The hard part is that the actions aren’t part of the narrative yet, making it very difficult to know where the market is going to head. The only thing I can recommend is: relax, take a deep breath, keep watching the VIX…and do not forget about these longer-tail effects once the COVID-19 narrative eventually gets replaced. When it comes to longer-term effects on the markets, actions tend to speak louder than words.

*Yes yes, I know that Pandemic Legacy: Season 1 is considered one of the best board games of all time, and it is an absolute tragedy that I haven’t played my copy yet. I’m not starting on the campaign until I finally win at least one damn game of Scythe.
**I was at a concert last night, right in the middle of the county that has seen California’s only death so far from COVID-19. Pepper and the audience didn’t seem too nonplussed by the outbreak.