Predicting the reaction of the stock market at this time is quite difficult. To do this, at least it is necessary to predict the direct impact of the coronavirus pandemic on the economy. In addition, the pandemic of financial stress is now covering the world. The two pandemics are completely different, but they are closely related.
As for the second pandemic, the fear is so strong that it captures a huge number of people around the world and it is extremely difficult to get rid of it. The stock market is plummeting in response to examples of how COVID-19 begins to drain the economy if timely and adequate action is not taken. But, unlike COVID-19 itself, the source of concern is the uncertainty about which steps to take.
And when two pandemics act simultaneously, nothing good can be expected. One supports the other. Company closures, rising unemployment, loss of income contribute to financial stress, which in turn prevents people losing their jobs, taking adequate precautions and protecting themselves from the spread of the disease.
When demand falls in only one country, losses partially extend abroad, and demand for a country’s export does not fall too much. However, this time the natural safety valve will not work, a recession threatens almost all countries.
Many people think that financial stress is nothing but a direct by-product of the COVID-19 crisis. And this is a perfectly logical reaction to the pandemic. However, such concern is not entirely justified. The financial stress pandemic, which affects the fall in prices, lives its own life.
The effect of financial stress on the stock market can be described by the term “heuristic affect”, mentioned by psychologist Paul Slovick of the University of Oregon and his colleagues. When people are frightened and crushed by some tragic event, they begin to fear even where there is no reason for fear.
For example, the work of scientists William Getzmann and Dasol Kim says that earthquakes that occurred nearby make people believe in the collapse of the stock market, which in scale will resemble the collapse in 1929 or 1987. If a strong earthquake occurred within the radius of 30 miles (48 km) in the previous 30 days, respondents believe that the likelihood of a stock market crash will be much higher. This is how heuristic affect works.
Maybe it makes sense to prepare for the stock market crash due to the coronavirus epidemic, and not because of the recent earthquake. However, it will not be on such a scale as recently. If everyone believed that treatment would help reduce the intensity of the pandemic in a few months or that it would last at least a year or two, perhaps the risk in the stock market would not be so great for long-term investors.
But contracting financial stress works differently than contracting a disease. People notice distrust of other people, prices start to fall, the reaction to this decline is exacerbated. A negative “bubble” in the stock market arises at the moment when people notice a fall in prices, try to understand why, and then begin to exaggerate stories explaining the decline. In the following days, prices fall, and so on in a circle.
Watching a consistent decline in stock prices, there is a strong sense of regret for those who did not have time to sell. This regret and fear fuel the main interest of the people in both pandemics.
To verify this, consider the example that the US stock market did not collapse when in September-October 1918 the media first began to cover the Spanish flu pandemic. She claimed 675 thousand lives in the United States (and more than 50 million lives worldwide). However, monthly US market prices rose from September 1918 to July 1919.
Why didn’t the market crash? Most likely, because in the foreground was the First World War, and not the story of the flu. Another reason was that epidemiology was in its infancy at that time. The outbreaks were not so predictable, the public did not fully believe the advice of experts, people did not so carefully observe the principles of social distance. In general, it was believed that economic crises are banking crises. And in the US there was no banking crisis, given that the Fed, which was created in 1913, was supposed to eliminate this risk.
But the most important thing is that 100 years ago, far fewer people had stocks. In addition, retirement savings were not such a problem as they are today: life expectancy was lower, in addition, many relied on family members in old age.
This time it’s different. The grocery stores panic. And in 1918, in wartime, food shortages were common. The great recession is behind us, and we are well aware of the possibility of a sharp fall in asset prices. Now there are no tragedies of the World War, and the United States is concerned about its own political polarization. And there are already a lot of angry reviews about the wrong behavior of the federal government during the crisis.
In a word, it is extremely difficult to predict the behavior of the stock market now. To do this, it is necessary to predict the direct impact on the economy of the coronavirus pandemic. And we must not forget about the real psychological consequences of the pandemic of financial stress. Yes, these are different phenomena, but in this case they are inseparable.