October 2020 | 

The Next Market Shock: Is Your Firm Ready to Handle It?

The Next Market Shock: Is Your Firm Ready to Handle It?

The current disconnect between the stock market and the economy has baffled individual investors, advisors, and financial managers alike, and it continues to make headlines. What does it mean for companies navigating the pandemic, and how should it affect their decisions? Wharton finance professor Itay Goldstein recently spoke about it with Wharton Business Daily radio, identifying three factors that help explain the market/economy disconnect.

But even armed with those insights, many finance leaders, managers, and individual investors are still confused about a path forward. Goldstein, who directs Wharton’s Advanced Corporate Finance program, says dealing with the current crisis — and those to come — requires taking a step back to examine how previous disruptions have been dealt with. “What kinds of vulnerabilities did these market shocks expose, and how did you, and others, react?” he asks, noting that looking to the past can provide important insights for today and for handling future shocks.

“The last six months have demonstrated that things in the economy and business environment shift very quickly. It has put managers and investors in new situations that they hadn’t thought about before. Throughout the week in Advanced Corporate Finance, we help them think through key financial decisions so they can determine how they should act in general situations and also under severe shocks like the one currently experienced.”

A case in point is the incorporation of information from stock market performance, Goldstein notes. “The market has a lot of useful information that managers should pay attention to,” he says. “But they need to interpret it with a lot of caution, understanding the subtleties and what is happening in the background.”

“Given that the market is so visible,” he continues, “and grabs so much attention, it’s where a lot of a people look to get signals on what to do. Because it’s positive today, that is sometimes being translated as an indication that a recovery is coming sooner than later. But, the true message to take away from the market is more subtle.”

Goldstein says context is crucial: today’s market performance reflects in part a government intervention that might not be there in the future. “In early to mid March, after the pandemic hit, prices were falling in the equity and corporate bond markets. There were also big outflows from mutual funds. There were clear signs that the markets could tumble further.”

The Fed acted quickly. Using the tools from their 2008–2009 playbook, they reduced rates and bought treasuries and government bonds. But they concluded that it wasn’t enough to stabilize the markets, and took the unprecedented step of buying corporate bonds and offering to lend money to firms. It worked. But, says Goldstein, concluding that you don’t need to worry because the Fed is there to step in and save the day isn’t the right takeaway.

“We shouldn’t trust that the Fed will always be there to stabilize the markets. They have limited tools. Every firm should go through the process of thinking not just about how to get through the current crisis, but also about how they will look when this happens next. Taking calculated risks means when there is another shock you might not be in a position to survive it. Managers need to decide what they can do to become more resilient.”

“Pre-pandemic,” he continues, “many firms’ capital structure decisions were about enjoying the benefits of debt. They believed the prospect of bankruptcy was remote, and the possibility of a shock like the last recession was minimal. This kind of optimism has resulted in a wave of bankruptcies. The current situation illustrates how important it is to understand where fragility can come from and what you can do to alleviate its effects.”

“When things are stable and waters are calm,” says Goldstein, “it’s easy to feel like you have everything under control. You don’t need to think about or do anything differently than you did before. But when you are confronted with a crisis like the current one, you realize there may be gaps in your knowledge and your skills. How do you manage today, and how do you situate your firm to be better prepared for a shock in the future? The program helps you think it through and provides tools to help finance leaders get through this process in calm water or big shocks.”