Feature Article: Why Did Markets Take So Long to React to COVID-19?

On 31 December, 2019, the S&P 500 closed at 3,230.78. That same day, the government in Wuhan, China, confirmed that health authorities were treating multiple cases of pneumonia.

On 6 January 2020, the Wall Street Journal reported that, in China, “medical authorities are racing to identify the cause of a mystery viral pneumonia that has infected 59 people in central China, seven of whom are in critical condition, and triggered health alerts in Hong Kong and Singapore.” The next day, the Financial Times reported that “health authorities are working to identify the outbreak of viral pneumonia that has infected at least 59 people in Wuhan [China]. Officials have ruled out Severe Acute Respiratory Syndrome, Middle East Respiratory Syndrome and certain types of flu.”

On 8 January, the FT reported that, “The world is already grappling with its first emerging disease of the decade. Dozens of people in Wuhan, a city in central China, have been hit by an unexplained pneumonia. There are no recorded deaths but, among 59 who have fallen sick, seven are reported to be in a critical condition with breathing difficulties. The authorities have ruled out seasonal flu, bird flu, severe acute respiratory syndrome (SARS) and Middle East respiratory syndrome (MERS). Singapore and Hong Kong are now screening air passengers for fever. The outbreak, which began in December, has been traced back to a market selling seafood and live animals such as bats and marmots. It has since been closed and disinfected. The possibility that yet another malign microorganism has hurdled the species barrier to infect humans is likely to boost calls for a global catalogue of animal pathogens.”

On 9 January, the FT reported that, “A pneumonia outbreak that has infected more than 50 people in the Chinese city of Wuhan was caused by a coronavirus, which is the same kind of pathogen involved in the deadly SARS outbreak in 2003, Chinese state media said on Thursday. The outbreak, which comes ahead of the lunar new year holidays in late January when millions of Chinese will be travelling to see their families, has caused alarm in the region. The virus has prompted widespread concern on Chinese social media and triggered memories of the 2003 outbreak of severe acute respiratory syndrome, or SARS, that infected more than 8,000 people worldwide and killed more than 700, including almost 300 in Hong Kong. The World Health Organization said, in a statement issued on Thursday, the Chinese authorities believed the disease ‘does not transmit readily between people’, but noted that it could cause severe illness in some patients.”

On 15 January, the FT ran a story headlined, “How Dangerous is China’s Latest Viral Outbreak?” This was its first paragraph: “An outbreak of a new kind of viral disease in China has led to widespread concern about the risks involved and fears of an official cover-up. A 2002-03 outbreak of severe acute respiratory syndrome (SARS) killed more than 800 people after Chinese officials covered up new cases for months, greatly worsening its spread. That has raised questions over Beijing’s handling of the latest outbreak that began in Wuhan, capital of Hubei province.”

On 14 January, there was a Democratic Candidate Debate.

On 16 January, Donald Trump’s impeachment trial began.

On 18 January, in a story headlined “Scientists Warn Over China Virus Outbreak”, the FT wrote that, “Concerns are rising over an outbreak of a virus that originated in China as leading scientists suggested that more than 1,700 people may already have been infected, far more than had been thought. Chinese health authorities said this weekend that they had discovered 21 more suspected cases in the central city of Wuhan, bringing the total number of suspected cases of the pneumonia illness in the city up to 62. But experts warn that there is significant uncertainty about the severity and spread of the illness, which has already killed two people and evoked memories of the SARS outbreak that killed hundreds of people more than 15 years ago. A study by the respected MRC Centre for Global Infectious Disease Analysis concluded that a total of 1,723 people in Wuhan City would have had onset of symptoms by January 12, the last reported onset date of any case. Neil Ferguson, a public health expert from Imperial College London, who founded the centre, told the BBC he was “substantially more concerned than I was a week ago”.

Later in the same story, it was noted that, “on Sunday, Li Gang, director of the Wuhan Center for Disease Control and Prevention, told state broadcaster CCTV that the information available ‘does not rule out the possibility of limited human-to-human transmission.’ ‘The infectivity of the new coronavirus is not strong,’ he added, referring to how rapidly the virus may spread between individuals. ‘The risk of continuous human-to-human transmission is low’. Most patients have presented relatively mild symptoms, Mr. Li said, and no cases had been found in more than 700 people who came into close contact with infected patients.”

On 20 January, the FT reported that “China Confirms Human-to-Human Transmission of SARS-like Virus”.

On 21 January, the World Health Organization issued its first Situation Report on the “Novel Coronavirus”. The same day, the FT reported that Asian stocks had fallen after Beijing confirmed human-to-human transmission.

On 22 January, the US confirmed its first case, a patent in Washington State who had returned from Wuhan. On the same day, the FT ran a story headlined, “How China’s Slow Response Aided Coronavirus Outbreak.”

On 23 January, Chinese authorities began their quarantine of Wuhan.

On 27 January, The Index Investor (@indexllc) posted its first multipart tweet about the new coronavirus, including initial estimates of its Case Fatality Rate, and key uncertainties for investors to monitor. Between then and today (16 March) we have posted 11 more (often multipart) tweets, covering new information that reduced uncertainties about the virus and its potential impact.

On 30 January, the WHO declared a global health emergency.

On 31 January, the US restricted travel to China. That evening, the UK officially left the European Union.

3 February: Iowa Democratic Caucuses.

On 5 February, Donald Trump was acquitted at the end of his impeachment trial. That same day, the Diamond Princess cruise ship was quarantined in Japan with 3,600 passengers on board.

On 7 February, there was another Democratic Candidate Debate. Earlier that day, in China, Li Wenliang, the Wuhan doctor who tried to raise the alarm about the new coronavirus (and was accused by the police of “rumormongering”) died after contracting it.

11 February: New Hampshire Democratic Primary.

On 12 February, Dr. Nancy Messonnier, Director of the US Center for Disease Control’s Respiratory Disease program, noted on a press conference call that, “the goal of the measures we have taken to date are to slow the introduction and impact of this disease in the United States but at some point, we are likely to see community spread in the U.S.”

On 18 February, in our new issue of The Index Investor, we wrote, “The Wuhan coronavirus will almost certainly depress global economic growth, by an amount that is highly uncertain at this point. Global aggregate demand has already been weakening. A worsening slowdown (or growth turning negative) will very likely be reinforced by mounting debt servicing problems in our highly leveraged global economy.”

On 19 February, the S&P 500 closed at 3,386.15, thus far the 2020 high. That night there was a Democratic Candidate Debate, the first one to include Michael Bloomberg.

On 20 February, the FT’s Gillian Tett titled her column, “Share Prices Look Sky High Amid Coronavirus Fears.”

On 23 February Italian authorities limited travel to 10 towns in the Lombardy region after a sudden increase in coronavirus cases.

On 25 February, Larry Kudlow, Director of the National Economic Council, said, “We have contained this. I won’t say [it’s] airtight, but it’s pretty close to airtight”. He added that, while the outbreak is a “human tragedy,” it will likely not be an “economic tragedy.” That night, there was another Democratic Candidate Debate.

At a 26 February press conference, president Trump said that, the current number of COVID-19 cases in the U.S. is “going very substantially down, not up.” He also claimed that “the U.S. is “rapidly developing a vaccine” for COVID-19 and “will essentially have a flu shot for this in a fairly quick manner.”

3 March: Super Tuesday Democratic Primaries.

On 15 March, there was another Democratic Candidate Debate, this time just between Joe Biden and Bernie Sanders.

On 16 March, after multiple trading stops, the S&P 500 closed at 2,386.13, down 29.5% from its February peak.

In the future, many people will ask the same question the Queen asked in the aftermath of the 2008 global financial crisis: “Why didn’t anyone see this coming?”

Our preliminary answer to that question is that it is very likely that multiple interacting factors were at work, including the following:

• We naturally resist the cognitive dissonance that is produced by evidence that severely contradicts our current system of interrelated and mutually supporting beliefs. One aspect of this is our tendency to avoid information that challenges our existing beliefs in a negative way, and to give more attention to evidence that supports our existing views (see “How People Decide What They Want to Know” by Sharot and Sunstein). Another is the way we subconsciously try to fit new discordant evidence into our existing world view by subtly adjusting our beliefs to incorporate it. As Daniel Kahneman noted in his book, “Thinking Fast and Slow”, it is only when this automatic adjustment fails that we note our feeling of surprise at a new piece of information and consciously reason about its potential significance.

• But as Tali Sharot’s research has repeatedly found, even our conscious reasoning is flawed because we often fail to fully incorporate negative information into our beliefs and our memories. Sharot finds that this is the root cause of our natural over-optimism bias.

• Another factor is that as uncertainty increases, so too does our natural human desire to conform to the views and behavior of our group, and to engage in more social learning (i.e., copying). In our evolutionary past this was undoubtedly adaptive; today it is not. When uncertainty increases, the number of diversity of narratives about the future by different members of a population tends to decline, making the system of beliefs more fragile, and susceptible to changes that are both sudden and large.

• As uncertainty increases, people are also more willing to discount conclusions based on their private information when those conclusions disagree with the dominant view in their group. This can allow an increasingly dangerous state to persist for long periods of time, until a strong public signal that is consistent with group members’ private information causes them to quickly and substantially update their beliefs all at once. However, if public signals are confusing or contradictory, the dominant narrative can remain in place, despite accumulating evidence that it is wrong.

• Another relevant shortcoming of human reasoning is our tendency to form beliefs by unconsciously matching the features of a current situation to similar ones that are stored in our memory (this is sometimes called “Retrieved Context Theory”). Our strongest memories are those formed by events that triggered high levels of emotional arousal and negative feelings (or “valence”). In this case, many people may have initially associated early reports about COVID-19 with vague memories of the relatively benign way the SARS epidemic played out in 2003. In the future, early reports of new respiratory viruses are almost certain to be associated with people’s much more negative COVID-19 memories.

• Another factor that may have contributed to assessment failure is that most people struggle to grasp the future implications of processes characterized by time delays and non-linearity, such as those that underlie infectious disease dynamics.

• It is also the case that when our mental energy has been depleted, we exhibit poor control over the allocation of our attention, and are therefore likely to miss important signals. In this regard, the early development of the Wuhan coronavirus crisis coincided with the Trump impeachment trial, multiple Democratic Candidate Debates, the Iowa Democratic primary caucuses, and the New Hampshire Democratic primary.

• Finally, in October 2019, the Economist estimated that 35% of public equities are now managed using quantitative processes. This presents a number of fundamental challenges when disruptive changes like the arrival of COVID-19 roil the financial markets. Most of these processes cannot detect, early on, changes that are not contained in the set of historical data on which they were trained, and/or which have not yet manifested in the signals they track (e.g., changes in sentiment or momentum). Because they are far better at causal and counterfactual reasoning (which quantitative techniques still can’t handle), human beings are still far more effective at making sense of the uncertainties that are inherent in highly complex, evolving systems like global macro.

Since 1997, the mission of The Index Investor has been to help investors, corporate, and government leaders to better anticipate, more accurately assess, and adapt in time to emerging macro threats. This mission provides a framework for answering the question, “Why didn’t anyone see this coming?”

It wasn’t due to a failure of anticipation. Over the years, multiple risk analyses have considered the potential impact of pandemics. For example, in its most recent analysis of alternative future scenarios (“Global Trends 2030: Alternative Worlds”), the US National Intelligence Council wrote this: “An easily transmissible novel respiratory pathogen that kills or incapacitates more than one percent of its victims is among the most disruptive events possible. Unlike other disruptive global events, such an outbreak would result in a global pandemic that directly causes suffering and death in every corner of the world, probably in less than six months.” We also included the possibility of a global pandemic in our January 2020 feature article, “Global Macro Risk Dynamics in the 2020s and Beyond.”

At The Index Investor, we have written about the risks posed by pandemic influenza many times since 1997, and have a substantial amount of information about this threat in the free research library on our website.

In sum, with respect to anticipation failure, COVID-19 was not a black swan.

Failure to accurately assess the threat posed by the Wuhan coronavirus after it appeared is a far better explanation for the human, economic, and financial pain and losses that many individuals and organizations have suffered.

Many of the factors that contributed to this failure are listed above. In the future, more will be discovered and discussed. As we noted, many of them are deeply rooted in human nature.

One of the most important lessons learned over the years at Britten Coyne Partners (The Index Investor’s strategic risk governance and management consulting affiliate) is that simply increasing awareness of them usually doesn’t reduce their impact. A far more effective approach is the consistent use of organizational processes that are designed to offset their potential negative impact. Such processes include, for example, the use of pre-mortem analyses, warning indicators, reference cases, and the systematic search for evidence that contradicts current beliefs.

Failure to adapt in time to a threat that was anticipated and accurately assessed has also have played a role, as it has so many times in history.

In some cases, this failure was probably rooted in system design (e.g., quantitative strategies and robo-advisors that were constrained to remain fully invested, and unable to shift into cash, or exceed certain allocation limits to less risky asset classes).

However, we suspect that the incentives faced by key decision makers played a far more important role, as it always does in cases of strategic failure. When managers are evaluated and compensated on the basis of beating the performance of a benchmark index, there is a very strong incentive to avoid selling too soon, even as they see downside risks increasing. This was famously summed up in former Citibank CEO Chuck Prince’s quote from July 2007: “As long as the music is playing, you've got to get up and dance. We're still dancing.”

Moreover, as organizations grow larger and become more concerned with efficiently scaling a successful business model, their culture usually evolves to one that penalizes errors of commission (“false alarms”) more heavily than errors of omission (“missed alarms”). In the face of disruptive changes in their external environment, this can be deadly.

A final cause of failure to adapt to emerging threats lies in the frameworks we usually use to think about and discuss them. Modern risk assessment has its roots in quantitative tools used by actuaries to estimate the probability and potential impact of discrete events (e.g., prices falling below a put option’s strike price, or the number and severity of hurricane related insurance losses in 2020).

What this framework leaves out is often critical. In a world of evolving uncertainty and novel threats, time dynamics are critical. The key concept is the changing relationship between how much time remains before an emerging risk reaches a critical threshold (e.g., when does it become a dangerous threat), and how much time is still needed before an adequate response to it can be developed and implemented. Boards, management teams, and individuals that closely monitor changes in gap (what Britten Coyne calls the “safety margin”) have a much better chance of adapting in time.

Strategic failure is a complex phenomenon that is always rooted in some combination of interacting individual and organizational failures to anticipate, assess, and act. COVID-19 is just the latest example of this process.