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Rekenthaler Report

Almost Nobody Knew

The bear market that arrived in silence.

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Inefficient Markets?
I was corresponding with several friends who own defined-contribution accounts, but who don’t closely follow the financial markets. They were perplexed by my comment that the Dow Jones Industrial Average had posted its record high on Feb. 12. By that date, China had recorded 70,000 COVID-19 cases, and the disease had reached the United States. How could stocks rise, even as a pandemic approached?

Their answer: Investors are idiots. By mid-February, they maintained, informed observers understood that the U.S.-- and other developed nations--would order lockdowns to control the spread of the coronavirus, and that such actions would wreak economic havoc. Apparently, though, none of those intelligent onlookers owned stocks. Only the dummies did.

Call that the anti-efficient market hypothesis, or AEMH. Per their claim, the financial markets are not all-knowing. Nor do mutual fund managers suffer from the paradox of skill. Quite the contrary. The reason that most equity funds trail the averages is not because competition is too fierce. It is instead because investment managers are dunces.

The Academic Response
I informed them they had it backwards. Stock prices are a certain indicator of what people understood at the time. Had there been any sizable recognition that the coronavirus would lead to mass business shutdowns one month later, that knowledge would have made its way to shareholders, and equities would have traded lower. That U.S. stocks were instead at record highs showed that my friends had used hindsight bias.

This did not convince them. They pointed out that no matter what evidence they furnished to demonstrate that the coronavirus crisis should have been foreseen, I would brandish my stock-market indicator, to “prove” that they were mistaken. When I responded that this was not solely my personal belief, being the consensus among finance professors, they laughed. So ended the conversation.

No question, my friends’ memories were flawed. In mid-February, the coronavirus had affected only scattered Chinese cities. Japan and Korea, now regarded as the economic coal mine’s canaries, each had only a handful of cases. The first Italian death would not occur for another 10 days. Events have moved so quickly that it is difficult to recall how different things were less than two months ago.

Nonetheless, their contention was worth considering. Had I argued unfairly? It is after all highly convenient to claim that because equity prices reflect all available information, the rest cannot be known. I set my previous answer aside and considered the topic afresh.

Caught by Surprise
Institutional investors, and those who serve them, are paid to investigate the smallest of investment issues. For example, the first entry for a Google search on “investment research 2014” is “The World Cup and Equity Markets,” by Goldman Sachs. If that is not technically the smallest of investment issues, then it surely must be close.

Yet before the largest stock market decline in more than a decade, Goldman seems to have been silent. I could find no publication from the company about the coronavirus until Feb. 28, by which time the S&P 500 had already dropped by 11%. That article’s title, “2020’s Black Swan: Coronavirus”, suggests the company’s mindset. A black swan cannot be anticipated. The implicit message is not to blame Goldman for being unable to forecast the unforecastable.

Apparently, one should not blame other research firms, either. Mainstream researchers (including Morningstar) almost entirely missed the looming problem. There were a few outliers. Hedge-fund manager Bill Ackman, (in)famous for his short of Herbalife (HLF), was the most notable, allegedly making a 10,000% profit by betting that corporate credit yield spreads would widen. Another hedge fund, Valiant Capital, also anticipated the chaos. Several bloggers sounded the alarm, too.

Their knowledge helped retail investors not a whit, because those people don’t run registered funds. Neither could institutional investors easily profit. Bill Ackman’s recent trades have benefited his Pershing Square Fund handsomely, and his fund also boomed last year. But it lost money in 2018, 2017, 2016, and 2015. How could institutions have known in advance that this would be his year?

Like No Other
I do not think that they could. Nor, I believe, could they be expected to have recognized this bear market. The New Era’s technology-stock crash was widely expected, albeit for several years before it occurred. The 2008 global financial crisis was less anticipated, but there certainly were more skeptics than portrayed in “The Big Short.” By summer 2008, warnings that real estate problems might jeopardize equity valuations were rife.

Even 1987’s crash, based on fears of a recession that never materialized, approached more noisily. There was a looming sense among investors, fed by the business press, that the stock market rebound had come too far, too fast, particularly as it was accompanied by rising interest rates. To be sure, few investment managers dodged Black Monday, but more than in 2020, including some mutual funds.

The problem is, the cause of this downturn looks like no other within memory. The last U.S. stock market decline that was associated with a disease occurred in 1920, and it’s debatable whether the Spanish flu had much to do with that outcome, since stocks rose during 1918, when the virus was at its deadliest. Investors have learned over the decades to fear inflation, recession, and speculative bubbles. Until now, they did not learn to fear infections.

Could the economic damage from the coronavirus have been predicted? Sure. Some investors did just that. Unfortunately for those attempting to profit from information, though, every year researchers predict dozens of events that never occur, or that do happen but have trivial investment consequences (for example, the Ebola virus hitting American shores). The better question is, should investors have recognized that, after many false alarms, the bear was indeed at the door?

No, I do not believe that they should have. Whether stocks were too expensive in mid-February, given this late stage of the economic cycle, can be debated. However, I do not think that they foolishly discounted the threat posed by the coronavirus. They were wrong, but rationally wrong.

Fresh Ideas
Among the suggestions made in my late-March column “This Economic Crisis Can’t be Solved by Conventional Thinking Alone” was that otherwise empty hotels put themselves to use by housing exhausted medical workers. Lo and behold, appearing in my email folder today was press release announcing that the American Hotel & Lodging Association is partnering with “the health community” to accomplish that very task. Good job, people!

John Rekenthaler ( has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.