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COVID-19 has created the mother of all binary risks

24042020_COVID-19

COVID-19 has created the mother of all binary risks

While COVID-19 is a humanitarian crisis, first and foremost, it has rapidly become an economic crisis too. And for investors in financial markets, the recent period of extreme volatility has done little to calm nerves.

Such volatility is often ascribed to “fears” in the market. But such an explanation is rudimentary at best. Indeed, if all investors were fearful at the same time, we would likely see equity markets just fall. But instead we have seen equities rise and fall by large percentage amounts each day. What to make of these seemingly bipolar mood swings by Mr. Market?

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Andrew Macken is the Chief Investment Officer of the Montaka funds and the Montgomery Global funds. He established MGIM in 2015 in partnership with Montgomery.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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8 Comments

  1. Andrew, when markets are rising at the moment do we know that it is because of positive information (hopes for a vaccine, that the R0 is not too bad and so on) or is because of government stimulus, monetary policy , fiscal policy, buying ETFs and the the like. Without government intervention one could argue that the risks for the downside (given the information we have) are vast and the potential upside is miniscule and hence price discovery should keep push prices downwards – like a bird in flight it can keep flying up and down but eventually gravity is going to bring it down to earth.

    • Hi John,
      I think that’s a very good point.
      The Fed’s balance sheet is up to something like US$6.3 trillion in acquired assets.
      The original owners of these assets then need to go buy other assets – and some of this liquidity ends up in the equity markets.
      This is surely helping push up equity prices – but not for strong fundamental reasons necessarily.
      All the best,
      -AM

  2. Michael Shapiro
    :

    Challenging time indeed. Thank you for a good summary of the dilemma we face. In my opinion, there are thousands of businesses around the world, listed and unlisted, that continue to increase earnings, with stable cash flow and clean balance sheets. If you invest in companies that have no or declining revenue or unsafe balance sheet, in a hopes of share price recovery (investing for capital gain), then how is that different to betting in a casino? Yes, you might experience intense regret if those companies will recover in share price later, but that’s no different to feeling regret when you didn’t bet on the red in the casino and it won in the next roll of the dice.

  3. Excellent article. The final factor to consider is how much markets will rally in the bull case VS how much markets will fall in the bear case.

    Given current valuations, I suspect markets could fall a lot if a bear eventuates with limited upside in the bull scenario.

    • Thanks Ricky,
      I agree with you that, especially after the recent rally, the range of possible outcomes from here is skewing towards the downside.
      All the best,
      -AM

  4. This article has definitely helped me better internalise something that has been ticking over in my mind. For me the binary nature of the risk means firms whose annual revenues I believe have the potential to collapse >40% in the case of protracted or rolling shutdowns are in-investible right now.

    Any other firm I can DCF with revenues substantially down (10-30%) over two years and earnings margins worsening in the short term.

    The real challenge, as it has been for a while, is selecting an appropriate discount rate. The sensitivity of my valuations with a risk free rate so low is so extreme, but the risk of missing opportunities due to too conservative discounting is also extreme. It’s truly a fascinating time to be investing!

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