The Great Dissonance: Part 2
The COVID-19 pandemic has caused huge turmoil in the economic ecosystem. Earnings forecasts have increasingly been volatile and underlying economic indicators have become unclear. Looking at the Efficient Market Hypothesis (EMH), it states that share prices reflect all information and consistent alpha generation is impossible. Stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices. It should be impossible to outperform the overall market through expert stock selection or market timing. Thus, it has brought confusion as asset prices continue to rise. This deviation of stock prices shows that there are factors that drive this phenomenon. Emergency fiscal and monetary plans including a unique debt monetization policy, the lowest central bank rate since 2016, and extensive consumption stimuli to offset the economic shock; investors flocked to the market hoping to ride a rebound causing asset prices to rise. Other factors have caused a detour in prices, where it then creates an unsettling ambiguity in an already unpredictable condition.
As asset prices are rising and international equities reach record levels, people worry whether the market will return to its pre-pandemic values or will it encounter a contraction known as a bubble. A bubble is an economic cycle that is characterized by the rapid escalation of market value, particularly in the price of assets. This fast inflation is followed by a quick decrease in value or a contraction, which is sometimes referred to as a "crash" or a "bubble burst.". Typically, a bubble is created by a surge in asset prices that is driven by exuberant market and investor behavior. Hyman P. Minsky states that there are 5 stages of a bubble; displacement, boom, euphoria, profit-taking/crisis, Panic/Revulsion. While each bubble may have its distinguishing characteristics, the key ingredients are a confluence of numerous factors: Innovation or the perception of it, speculative leverage, and the emotion and psychology of investors – collective delusion. It is most likely we are already in phase III which is euphoria as on (12/18) it was predicted that market will keep climbing until 2021 which we feared a bubble burst would eventually come like The Tulip Mania in 1636 in Holland or the Japanese "bubble economy" in the 1980s.
It has become more challenging to make profitable investments in an erratic and fluctuating market. Several strategies to prosper in the market depends on the investors’ risk tolerance, investment time horizon, and overall objectives. Selling out / capitulation, playing defense, shopping for bargains, and finding assets that increase in price are some of the strategies to gain profit in the pandemic uncertainty. But again, how will the immense turmoil in recent history change the capital market landscape for years to come? Coronavirus had an immediate impact on all business sectors around the world. Some have thrived, but the majority have been adversely affected. It’s difficult to quantify precisely how much global capital markets will be affected by the pandemic. What we have seen, however, is that structured finance and capital markets encompass a variety of asset types that have been directly affected by the outbreak. That said, there is clearly an increase in global debt, resulting in outcomes. In going forward, it is expected that there will be a massive restructuring, loans, and securitization, an increase in ‘COVID-19 loans’, a new kind of CLOs in the market, and indeed more consolidation and higher monitoring requirements. The reality is that we are in the midst of a seismic shift that will continue to roll out for some time.