It is easy to forget that at this time last month the stock market was still making new all-time highs. It has only taken a few weeks for the decade-plus bull run to hit bear market levels, highlighting just how unprepared the world has been for the novel coronavirus disease (COVID-19) pandemic. Financial markets took a massive spill downward in February as investors began to realize the enormous impact the outbreak will likely have on the world economy. The S&P 500 index chart perfectly illustrates the turning point when the seemingly endless market optimism was strangled by newfound fear.
The first half of the month actually saw markets make new all time highs despite the growing scale of the COVID-19 outbreak that triggered a downturn at the end of January. The divergence between the optimistic market attitude and the growing danger to the world economy reflects how entrenched the “buy the dip” investor philosophy became over the course of the longest bull market through the last decade. For many investors, the improving situation in the trade war and signs of a global economic rebound justified new market highs and the belief that the outbreak would be a passing threat.
By the latter half of the month, COVID-19 was clearly becoming an epidemic; and it was dawning on markets that the economic disruption that had hit China was likely to metastasize throughout the world in one form or another. This realization ignited the concern among investors into full-fledged fear, and for good reason. As we saw in China, fear of the contagion and government intervention for public health can grind consumer activity to a halt, stifling businesses such as retailers and services that rely on consumers. Industries that support those businesses like logistics and energy are hit next, forming a collapsing domino line that extends throughout all sectors of the economy. Writ large, this effect on multiple countries across the globe could spark a wave of economic recessions and contribute to a worldwide economic collapse if the outbreak proves unable to be contained.
The tipping point for investors came in mid-February, resulting in a market jolt after reaching new highs and turned into a run on the markets that morphed into a full blown crash down to correction levels in just a week. The drop in February erased the gains for the year and reversed last year’s holiday rally; but even then was just the start as the crash has continued in March and the full extent of the COVID-19 pandemic has yet to fully play out.
The speed of the crash in February was a surprise and did make a mark on our performance; however the innovations we have made to our trading strategy to reduce risk exposure and constrain our risk ceiling helped to keep our loss minimal. In fact, despite the market turmoil, we managed to maintain a slight positive profit in February as our gains in the first half of the month offset the crash in the second half.
When stock market indices successfully recovered from the drop at the end of January, it seemed like financial markets would continue higher as had become the norm over the past several years. This is the kind of market we were familiar with, and were able to generate a steady positive performance. In retrospect, there was clearly something wrong with the divergence between growing outbreak at the time while the stock market was making new highs. In general, however, our strategy has always been to trade the market as it is, rather than what we think it should be.
In this case, we believed a drop may have been coming, but were unprepared for the speed of the downturn. The exploding volatility as stocks plummeted ballooned our risk and we were forced to cut some positions for a loss to prevent further bleeding from the portfolio. However, our constrained risk strategies that we developed and implemented over the past year helped to control those losses and prevent them from becoming magnified further.
Our successful use of this risk safety net prevented us from going into the negative for February; but just as importantly has also put us in a significantly advantaged position going forward. Historically, we have been able to generate much stronger profits in the volatile aftermath of events such as these; however we have also needed months to fully recover from the initial loss these events bring. In being able to minimize this loss, we are in a stronger position than ever to deliver a standout performance for our investors at Lockbox Capital.
*Incentive fee is calculated at twenty percent based on the difference of the high watermark and ending account balance for the Incentive Allocation period.