Coronavirus and price discovery during black swan events
The market has experienced more volatility in the past month than it has over the entire past decade since the start of the 2008 financial crisis. Moreover, the S&P 500 fell by 20 percent on Thursday, relative to its peak, which led to a 15-minute halt on trading. These recent patterns are in part a reaction to the recent classification by the World Health Organization (WHO) of the coronavirus as a pandemic and the perception that there is not a coordinated global response that will lead to containment.
By all accounts, this is what Nicholas Taleb refers to as a black swan event: a rare and unpredictable shock to a system with large-scale ramifications. Black swan events are defined by periods of high uncertainty and volatility, which is a sign that the market is having a tough time in the price discovery process. Price discovery is the fuel for markets, so when interactions between buyers and sellers break down, the market and consumer confidence declines. That’s why panic in the funding and securitization markets was a primary driver behind the severity of the 2008 financial crisis.
The coronavirus (COVID-19) has led to a deterioration of price discovery in the past few weeks. Fear about tail-risks, even if they are low probability, has led to many cancellations of conferences, declines in flights and even school and university closures. Some airlines are even saying that the drop in demand has been even more severe than the decline experienced following 9/11.
Each day that goes by provides new information about the scale and severity of the challenge. How do markets respond to changes in the number of new confirmed cases versus deaths? On one hand, the number of deaths is ultimately the object of interest. On the other hand, new confirmed cases provide a glimpse of where the virus may be headed, serving potentially as a leading indicator for the scope and severity of the pandemic. Moreover, the location of confirmed cases and deaths may reveal new information that helps investors understand where the virus is headed.
Using data on daily stock returns across all publicly traded companies from the start of January to the present, the market did not begin responding that strongly until new cases began emerging in Italy. The virus barely registered on the radar of financial markets when the virus was limited to China. In fact, in mid-February the market almost moved past concerns about the coronavirus in China.
There are at least two reasons for this. First, the market may have viewed public health developments in China as uninformative for the West due to, for example, differences in the quality of public health infrastructure and rapid response teams. Second, the market may have not trusted information coming out of China all together, making the information more noise than signal.
If it was not the deteriorating situation in China during December, January and even early February, the market began to take notice. Returns responded sharply to increases in the number of new confirmed cases, particularly the surge that took place in Italy. Interestingly, however, returns appear to be largely uncorrelated with changes in the number of deaths after accounting for the number of new cases.
What does the market response to the spread of the coronavirus across Europe tell us about the process of price discovery and the foreseeable economic consequences over the upcoming weeks? For starters, all eyes are on the United States and its ability to coordinate containment strategies across not only state and local governments, but also across countries.
The Coronavirus Task Force, led by Vice President Pence, is an important illustration of the priority that the Trump administration has placed on coordinating the response across the entire federal government. Moreover, the fact that the market is more sensitive to the revelation of confirmed new cases over deaths suggests that a rebound is unlikely to take place until new cases begin plateauing for a one to two week period, given that the WHO reports an incubation period of 1-14 days (with a median of 5 days).
To mitigate economic damages in the interim, the Trump administration is considering a wide array of stimulus efforts that would help provide a cushion for small business and hourly wage workers who are facing a particularly large challenge in taking time off and compensating for the decline in consumer demand. To facilitate these efforts, President Trump and other administration officials met Wednesday with leading executives from the financial services sectors, achieving broad agreement over several vehicles to maintain financial stability through the provision of credit.
President Trump has come under some criticism by House Democrats for focusing on the economy, rather than on “people.” However, it is important to recognize the synergistic nature of economic and health outcomes during a pandemic. If the economy were to substantially slip, we would not only lose significant gains that have accrued to the American worker, but also risk jeopardizing the very stability and social cohesion that allows public authorities to do their job.
While black swan events might be impossible to predict in advance, our response to them can follow a consistent pattern: Integrity, unity, clarity of thought and unrelenting perseverance. The road ahead might be bumpy, but it is a road we’ve traveled before and can get through once again.
Christos A. Makridis (Ph.D., Stanford University) serves as a (research) assistant professor at Arizona State University, a digital fellow at the MIT Sloan Initiative on the Digital Economy, a non-resident fellow at the Harvard Kennedy School of Government Cyber Security Initiative, a non-resident fellow at the Baylor University Institute for Studies of Religion and a senior adviser to Gallup.
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