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2020-spring-semi-variance

That Semi-Variance Yuck

Few people have fond memories of statistics class. From complicated formulas to confusing interpretations, for most, stats class was a hurdle to a diploma and an exercise in memorization followed by an immediate flushing sound. A colleague once told me that if I ever find myself using the statistical term semi-variance with a prospective client, […]

Few people have fond memories of statistics class. From complicated formulas to confusing interpretations, for most, stats class was a hurdle to a diploma and an exercise in memorization followed by an immediate flushing sound. A colleague once told me that if I ever find myself using the statistical term semi-variance with a prospective client, I should consider the prospect lost.

I get it. Technical talk isn’t slick. Yet semi-variance is exactly what grips you when markets fall. It’s why people lose sleep at night. When markets rise, the variability of that upward trend is exciting; we high five and wonder, “how high can it go?” When markets fall, the variability of the fall, that semi-variance yuck, is why you worry, wring your hands, and think about bailing on carefully planned long-term investment plans.
The recent news cycle has COVID-19, better known as Coronavirus, all over it. Many attribute the equity market’s February fall to it and its possible reaches. A pandemic has broad implications for global supply and demand. Economic activity requires people to create and consume; pandemics limit both sides of that equation.
The Toyota Production System was popularized in the 1970s. More commonly known as just-in-time manufacturing (JIT), it relies on steady production, high-quality output, and a reliable supply chain. Building large inventories just-in-case is no longer necessary. The spread of COVID-19 or any other pandemic puts JIT at risk, making supply chains unreliable. Moreover, China’s importance in supply chains is unquestionable. That a China originated epidemic could progress to a global pandemic means even less reliability in global supply.

On the demand side, the spread of COVID-19 curbs consumption. Empty streets in Wuhan, a city roughly the size of New York City, are a visual reminder of how quickly demand can dry up. So, what, you might ask. Order out, have it delivered! Recall that those services may not be as reliable as they once were because supply has been disrupted.

All of this can lead to at best a delay and, at worst, destruction of demand. If COVID-19 is contained, these problems largely subside, and delayed demand likely reappears in the coming quarters. If it worsens, prolonged decreases in supply and demand could lead to a global slowdown, or worse, recession. Most importantly, unlike a financial crisis that can be combatted by central bank tools, the Fed cannot stop a pandemic. It is hard to see how lower interest rates, or another round of quantitative easing could stop the spread of a virus and stimulate economic activity.

Back to semi-variance! Uncertainty about bad things leads to increased downside volatility and sometimes sharp market selloffs. Nobody knows how far COVID-19 will go, so markets discount equity prices. A company facing supply disruptions and a loss in demand for its products cannot be worth as much as it was before the threat of a pandemic. There are winners and losers, of course; a videoconference services company may benefit wildly from a pandemic as business travel declines.
What’s worse about falling markets today is we are not behaviorally conditioned for it. The S&P 500 has been up in nine of the last ten years, averaging 13.6% per year at the end of 2019. We must remind ourselves that times of uncertainty require buckling your chinstrap, evaluating your situation, and riding out periods of trouble. Since the beginning of time, a million news articles could have been extrapolated to forecast the end of the world, yet here we are.

In virtually all aspects of life, rash decisions do not translate into long term success. There are scarier things out there than COVID-19; they just aren’t at the forefront of the news. This is not a doomsday note but rather a reminder that when your investment account value falls, your emotions should never be your first defense. Whether or not a pandemic ensues, your long-term investment plan should still allow you to sleep at night without worrying about the day-to-day fluctuations in the market – because if it’s not one thing, it’s sure to be another.

Past performance is no guarantee of future results. Securities offered through M Holdings Securities, Inc., a Registered Broker/Dealer, Member FINRA/SIPC. Investment Advisory Services offered through Cornerstone Advisors Asset Management, LLC, which is independently owned and operated. 2978944.1

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