Coronavirus: Trading an uncertain market

How to navigate volatility if you are actively trading stocks amid coronavirus fears.

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It's been a roller coaster ride for stocks thus far in 2020. Coronavirus has unnerved parts of US and global markets to varying degrees, and struck stocks massively during the last week in February. The aftershocks are still being felt this week.

As fears of a contagion spread, US stocks—as measured by the S&P 500—suffered their worst week last week since the financial crisis, losing 11% ($5 trillion in wealth was lost from markets globally). That weekly decline wiped out all of the gains made for US stocks since July 2019 (coincidentally, when the Federal Reserve started cutting rates again in their last easing cycle—more on this past Tuesday's surprise rate cut later). What's particularly striking is how quickly the drop occurred (see Fastest correction in the S&P 500 on record chart). It took just 6 days for the correction (a loss of 10% or more).

Stocks did bounce back in a big way at the outset of this week, with the S&P 500 gaining 5.1% on Monday—the largest single day price gain since 2009—along with another 4% on Wednesday. But they gave back 3% on Tuesday and another 3% on Thursday. While this volatility can make trading difficult for some active investors that are not trading volatility, it’s critical to put the recent market action in perspective.

Take a look at the multiyear chart of the S&P 500 below, which shows stocks still significantly higher from the depths of the financial crisis, and even several months ago (see The long-term trend for US stocks has been very bullish chart). Indeed, when factoring in the recent correction (and this week's action), US stocks are up 12% over the past year, 49% over the past 5, and 180% over the past 10, on a price return basis.1

It's worth noting that, as stock prices have declined, valuations have moderated. A case can be made that they have come in line with the earnings growth seen over the past several years, although earnings growth could slow. The S&P 500's next 12 months price-to-earnings (P/E) is currently near 17, compared with a near-term peak of 19.1.2 These improved valuations are now roughly 4% and 7% above the 20-year average and median P/E.2

News driving the action

For the foreseeable future, new cases of coronavirus, potential treatments/vaccines, and global efforts to contain the spread could be significant factors shaping your short-term strategy. Key sources of this information include the World Health Organization (WHO) and Centers for Disease Control and Prevention (CDC). Sources of financial information regarding the potential economic impact include the World Bank and the Federal Reserve. Information from these institutions, as well as many others, may be worth monitoring closely as it could have an outsized impact on market direction over the short term.

When the Fed surprised many on March 3 by announcing an emergency 0.5% rate cut, citing the effects of coronavirus on global economic activity as a primary reason for the move, stocks gyrated in both directions (the Dow Jones Industrial Average, for example, swung 1,300 points intraday) before settling down nearly 3%. Fed funds futures now indicate a relatively strong chance the Fed could cut rates to near 0% by year end. Other central banks may provide additional support, and fiscal stimulus from governments may be forthcoming to help offset coronavirus-related slowdown.

Trading coronavirus

New announcements, like the unscheduled Tuesday Fed rate cut (and the subsequent market response), highlight how volatility may dominate over the short term.

Market timing is exceedingly difficult, and increased volatility may make it even more difficult. Below we discuss several active investing strategies and potential modifications amid a volatile market. If you are an active investor attempting to navigate the market with some percentage of your investment portfolio, it may be worth taking a more conservative approach while volatility persists. All of these strategies have varying degrees of risk involved, and before implementing any of them you should ensure that they align with your objectives and risk tolerance. 

  • Sector rotation. An active investing strategy that includes rotating a greater percentage of your trading funds to cyclicals (e.g., energy, consumer discretionary, industrial, financial stocks) when risks are relatively lower and to defensives (e.g., consumer staples, utilities, health care stocks) when investing risks are higher. Over the past week, defensive sectors have—for the most part—performed better than cyclicals. Exceptions have been the technology and communication services sectors, which are considered cyclicals and have been top-performing sectors during the recent coronavirus-induced volatility.
  • Avoiding or limiting exposure to industries that may have a strong coronavirus correlation. If part of your strategy is to limit exposure to volatility, it may help to identify and monitor those industries that may be impacted by coronavirus exposure to a greater degree than others. Industries with greater exposure to the mal-effects of coronavirus include, but are not limited to, travel companies, airlines, as well as those that have supply chains in regions of China with a relatively high number of coronavirus cases, such as some tech companies, apparel makers, and industrial equipment makers.
  • Min vol ETFs. These are funds that attempt to help reduce exposure to volatility by tracking indexes that aim to provide lower-risk alternatives. Of course, "min vol" ETFs do not guarantee against losses, and tend to offer below average participation in the upside. However, most of the largest types of these funds have incurred smaller losses relative to the broad market as measured by the S&P 500.
  • Shorting. This involves potentially profiting on stocks that decline in value by selling "borrowed" stock at the current price, then closing the trade by purchasing the stock at a future time. The primary risk of shorting a stock is that it will actually increase in value, resulting in a loss. The potential price appreciation of a stock is theoretically unlimited and, therefore, there is no limit to the potential loss of a short position. If you can accept the risks of shorting, and you are trying to make bearish directional trades, one strategy may be to tighten closing limit orders to help protect against losses. Of course, this increases the risk of locking in a loss during volatile markets if prices rapidly swing higher, and it may not be prudent for active investors to short into a market like this.
  • Options. The buyer of options has the right, but not the obligation, to buy or sell an underlying stock at a specified price on a specific date. If you are trading options, and depending on your strategy and outlook, a preference for purchasing calls or puts (rather than selling calls and puts, which entails more risk—particularly for naked positions) may help manage your risk. The reason: When you buy options (calls or puts), you know the maximum potential loss (the option premium).

Investing implications

Coronavirus and its potential effects on global economic activity is a unique risk factor that provides a strong reason to consider reassessing your portfolio to ensure it aligns with both your short- and long-term objectives.

Looking ahead, the hope for both those that have been directly affected by the virus—along with everyone else—is that the virus is contained and abates quickly. In the meantime, the stock market may continue to be sensitive to coronavirus developments.

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