Lessons From 2020: Market Edition Pt 2

January 26, 2021

Continuing from part 1, here are two more market lessons I took away from 2020.

3.) The risk you are expecting is usually not the risk that triggers a downturn in the market. Risk management is crucial in portfolio construction. If risk isn’t properly managed it is very easy to suffer large losses with any investment strategy. This risk is managed by protecting against expected risks and unexpected risks. Everyone focuses a lot of attention on expected risks because unexpected risks often come in the form of events that no one could have seen coming. 2020 was a great example of this. The obvious unexpected risk was the coronavirus and the response to the coronavirus. The unexpected coronavirus led to the largest market downturn in over 10 years. Following the coronavirus downturn, the election was the biggest event that every market analyst was targeting. The narrative of risks in the market centered around the election. Surprisingly, when the election came around the stock market reacted by going up. It went up despite the delayed results and the calls for election fraud. This really showed that when everyone is hedging against a particular risk, the likely scenario is that even if the risk materializes it won’t create the negative impact everyone would expect. When everyone started unwinding their hedges it pushed prices higher. The takeaway is that the risks that need to be managed are the ones that aren’t part of the main narrative. This requires having a contrarian viewpoint in a lot of regards because if you’re following the same narrative everyone else is following you’ll be just as unprepared as everyone else.

4.) When the Fed talks, you better listen. A key takeaway during the midst of the Covid correction is the extent the Federal Reserve will go to support capital markets. The Federal Reserve’s actions have a direct impact on capital markets. Much of what they do – regulating financial institutions and conducting monetary policy – is directly tied into asset pricing models. For example, cutting interest rates will cause both bond prices and stock prices to rise in most cases. In the case of bonds this is because held bonds now have a higher interest rate than bonds being issued, making them more valuable. In the case of equities, it is due to the relative value. When bond yields are lower, equities become more attractive. Over time, the role of the Fed in the economy has changed, but we learned in 2020 that they will go to great lengths to keep the financial system functioning efficiently. In 2008, the Federal Reserve provided support to the financial system, but it was much slower acting and less impactful. In 2020, the actions of the Fed were much larger and much faster than they were in the past. This is possibly the main reason why markets were able to recover so swiftly this time around. I also think that the narrative that is created by these actions and by Fed chair speeches is possible more impactful than the specific policy measures taken. The actual actions of the Fed were mainly limited to bond purchases and interest rate cuts, but because they acted in such a large-scale manner and reassured the market that they would go to the utmost lengths to support the economy, it brought confidence back into the financial system.

There are probably enough takeaways from 2020 to fill several books, but these were just a few of my takeaways from last year’s market action.

< Back to Insights