The Covid-19 crisis will go down in history as one of the most severe and unpredictable events in modern times.

It is therefore no surprise that the Chicago Board Options Exchange Volatility Index (VIX index), a measure of fear and risk aversion in markets, surged to an all-time high of 83 in mid-March, although it has halved in value in the past two weeks.

Covid-19 is a health crisis that has snowballed into a potentially severe economic crisis. The virus has forced governments to shut down their economies to safeguard their citizens, and in so doing, induced an economic downturn which ironically, governments are now trying to mitigate through aggressive policy measures.

The severity of Covid-19’s economic impact is unquestionable. We have already seen a large surge in jobless claims in the United States (US) and a plunge in economic activity in many parts of the world. The sizeable fiscal stimuli unleashed by governments the world over underlines how severe the current crisis is.

Despite all this, stock markets, which plunged by more than 30% initially over a two-month period, surprised many by bottoming out around 23 March before staging a strong rebound of 22% in the past two weeks.

Ironically, the US, which saw a surge in Covid-19 cases in recent weeks, and now has the greatest number of cases worldwide, saw its stock markets stage the strongest rebound amongst the major global regions.

What’s behind the recent rally?

There are at least six factors that can explain the recent stock market rally.

Firstly, investors are hopeful that the infection numbers in US and Europe which have surged and overtaken China, will start to plateau and the curve in these regions will flatten soon. No doubt, there are signs of improvement, but it remains to be seen if they are sustainable.

Secondly, the fact that China has lifted its 76-day lockdown of Wuhan, which was the epicentre of Covid-19 crisis, has resulted in optimism that other countries can contain the virus if they undertake aggressive measures.

Thirdly, central banks and policy makers have unleashed unprecedented, sizeable and somewhat co-ordinated policy stimulus to mitigate the negative impact from Covid-19, with the promises to do even more if necessary. This has offered reassurance to investors and helped to lift sentiment.

Fourthly, the more than 30% sell-off in the two months to 23 March (when stock markets bottomed), was partly precipitated by the unwinding of leveraged positions. Low interest rates in recent years has resulted in greater leverage in stock and bond markets and the initial and sharp sell-off in markets was worsened by margin calls. Deleveraging seems to have eased in recent weeks and this has helped to ease selling pressure.

Fifthly, investors are hopeful that a treatment or a vaccine for Covid-19 may be found soon, although historically, such medical discoveries can take months or even years, and even then, success is not a guarantee.

Finally, markets were looking attractive in terms of valuation after the more than 30% sell-off and this led to bargain hunting.

Is the bull back or is this a bear trap?

The truth is no one really knows. The Covid-19 crisis is unprecedented in history. Past crises like SARS, the Asian Financial Crisis and the Global Financial Crisis cannot be used as guide.

A key question is how long this Covid-19 crisis will last? No one knows the answer to this either. If it drags out and lasts, for say, more than 6 to 12 months, the economic damage can be quite severe and policy makers who have fired much of their ammunition may have limited options to respond.

Bear in mind that Covid-19 is a health crisis, and while economic policy can help to reduce the pain, it can’t help companies to grow their businesses as long as lockdowns are still in place and the international movement of people and goods remain restricted.

The fact that Covid-19 has become a global pandemic also complicates things as countries may not be in a hurry to open their borders until the virus has been effectively dealt with internationally, and the World Health Organisation deems it to be no longer a threat. This may not happen anytime soon.

While Covid-19 data in the US and Europe have shown improvement, it is still not clear if this is sustainable and the risk of a second wave of infections cannot be discounted if restrictions are lifted too early.

Markets will stay particularly sensitive to any evidence of secondary infection waves in China which incidentally reported 42 additional confirmed Covid-19 cases on April 9, with 38 of them from abroad. Meanwhile, Italy and Spain are preparing for several more weeks of lockdowns, while India further tightened measures.

Markets are also only starting to find out how badly Covid-19 is impacting the economy and earnings. As data is unveiled in the coming weeks and the corporate earnings seasons gathers pace, more surprises may be in store and it will be interesting to see what corporate CEOs say about Covid-19 and how it’s impacting their businesses.

What should investors do?

The only thing that investors can be sure about is uncertainty. There are still many unknowns about Covid-19 and it will be imprudent for investors to throw caution to the wind and jump headlong into stock markets simply because they have rebounded in recent weeks.

At the same time, if Covid-19 infection numbers surprise, by continuing to decline or even fall sharply, markets could continue to rise sharply on the back of optimism and the abundance of liquidity aided by unprecedent stimulus.

The best strategy to adopt now is to buy incrementally through dollar cost averaging instead of trying to time the markets. Also, focus on quality names which have strong balance sheets and the ability to bounce back when Covid-19 is no longer a threat. Consider companies that pay good dividends and can sustain pay outs as well, as central banks have cut interest rates sharply due to Covid-19.

Even if Covid-19 comes to pass, it may bring about significant and permanent changes in the way individuals and business function.

For one, technology has been a big enabler in keeping people connected during Covid-19 and it has allowed them to purchase goods and services online despite the lock downs.

Companies which offer the requisite technology or embrace technology to facilitate connectivity and deliver goods and services online to consumers and businesses, stand to benefit. Covid-19 has clearly given Ecommerce a big boost.

Companies that offer cyber security also stand to benefit as online activity could pick up sharply after Covid-19.

Globally, healthcare spending could also increase sharply after Covid-19 comes to pass, and this could throw up opportunities for investors as well.

So Covid-19 may not be all gloom and doom. There are silver linings and it can throw up investment opportunities not to be missed. But this is certainly not the time to throw caution to wind and turn too aggressive.

Do your research and be selective in what you buy. But most importantly, time diversify your investments and buy gradually, as we may not have reached the final chapters of the Covid-19 saga.

This article was contributed by Vasu Menon, Executive Director of Investment Strategy, OCBC Bank, and was first published in The Straits Times on 13 April 2020. Link: https://www.straitstimes.com/business/companies-markets/is-the-stock-market-rally-for-real