Out of Left Field

THIS MONTH MARKS the five-year anniversary of the start of the pandemic. That makes this a good time to look back and ask what lessons we might learn.

In early 2020, when COVID-19 was first identified in the U.S., the stock market dropped 34% in the space of just five weeks. But later in the year—after the Federal Reserve stepped in with its bazooka—the market rebounded, ending the year in positive territory. For full-year 2020, the S&P 500 actually rose 18%. Most remarkably, from the low point in late March to the end of the year, shares gained 70%. This provided a unique opportunity for investors who had the fortitude to rebalance their portfolios and buy stocks when things looked bleakest.

But that, of course, is easier said than done. During times of crisis—when the market presents what should be attractive buying opportunities—several factors conspire against us. It’s worth understanding these dynamics so we can recognize them the next time a crisis rolls around.

The first dynamic is what you might call the Mark Twain effect. An aphorism attributed to Twain is that history doesn’t repeat, but it does rhyme, and that certainly applies to the stock market. When it comes to market downturns, historically they’ve all ended the same way—with the market recovering and eventually going higher. But that’s the easy part. Where they’ve differed—and where they probably always will differ—is in their origins.

In the 1970s, it was an oil embargo. It 2000, it was the bursting of the technology bubble followed by the attacks on 9/11. In 2008, it was the failure of Lehman Brothers. In 2022, it was inflation.

Because each crisis is so different, no one can be sure how bad it will get or how long it will last. And because of that, each one feels uniquely terrifying. That’s typically what causes markets to drop suddenly at the start of a crisis. But unfortunately, that only compounds the atmosphere of panic.

Because of this panic, logical thinking tends to get tossed aside. That’s the second dynamic we see during crises. Back in 2020, I suggested a thought experiment to help combat this. The idea was to imagine an unrealistically extreme scenario and then to calculate the effect on the stock market. This requires just a simple three-step process.

The first, for simplicity, is to choose a single company for this analysis. Next, make the extreme assumption that the company might lose an entire year of profit as a result of the crisis. Finally, use a valuation technique known as discounted cash flow to calculate how that lost year of profit should—strictly according to the numbers—affect the company’s stock price. The premise of discounted cash flow is that it assumes a company should be worth the sum of all of its future cash flows, adjusted for inflation.

For this exercise in 2020, the company I chose was Procter & Gamble, which makes things like soap and shampoo. Let’s revisit how the numbers would have looked to an investor at the start of the pandemic.

At the time, P&G was worth about $300 billion and was earning about $10 billion a year. Therefore, to assess the impact of losing an entire year of earnings, we would simply subtract $10 billion from P&G’s market value. The result: P&G shares should have been worth just 3% less. After all, $10 billion is 3% of $300 billion. But because of the panic and the absence of logical thinking, P&G’s shares fell more than 20% in the early days of the pandemic.

Of course, some companies will always fare better than others during a panic, so you might repeat this exercise using other representative companies. The key conclusion would likely be the same, though: Stocks almost always drop to irrationally low levels during crises because panic replaces logic. But as the P&G example illustrates, market downturns usually represent buying opportunities—not based on faith but on the numbers.

Why does logic go out the window when crises occur? One cause is the din of storytellers. Especially during crises, market commentators go into overdrive. And since it’s anyone’s guess how things will turn out, they’re free to paint whatever picture they wish. You might wonder, though, why anyone would listen to them. We all know no one has a crystal ball.

Psychologist Steven Pinker offers an explanation. For evolutionary reasons, he says, our minds have learned that to survive, we must always be looking to make sense of the world around us. In fact, for survival, it’s critical to understand cause and effect in our environment. But that’s a problem, Pinker says, because sometimes this part of our brain gets carried away, telling stories and drawing conclusions even when they’re completely made up. The mind, he says, becomes a “baloney generator.”

Unfortunately, the media contributes to this phenomenon. Look at a financial news site, and you’ll notice that many of the headlines are presented in this format: “Market Rises as Inflation Fears Cool.” At first glance, this might seem like a perfectly reasonable statement.

The problem, though, is the word “as,” which implies a cause-and-effect link where one may not exist. I call that a problem because, on any given day, innumerable variables combine to drive the market in one direction or another. Headlines like this, however, lead investors to believe that these relationships are simple, scientific and predictable when they’re not.

Economic experts also contribute to this problem. In April 2020, the managing director of the International Monetary Fund referred to the pandemic as “humanity’s darkest hour.” Around the same time, a well-known hedge fund manager commented on TV that “hell is coming.” To be sure, the pandemic was terrible, but hyperbole like this, in my view, only contributes to the sense of panic.

The pandemic is—thankfully—in the rearview mirror, but we’ll face other crises in the future, and they’ll probably arrive just as COVID did: entirely out of left field. That’s why it can be helpful at a time like this, when markets are strong, to be sure your finances are prepared for whatever might come next.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam's Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.

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