As investors, we need to think about coronavirus. I’m not going to review what the virus is or attempt to sort through the science and forecast whether a sense of alarm is warranted. I’m going to focus on the story of coronavirus and the stock market.

Stock prices have always been tied to stories. One example is Tesla (Nasdaq: TSLA), a company that has a great story in electric cars and solar energy, but whose execution is spotty and whose CEO is erratic.

Despite the blemishes in operations, the stock trades at more than 100 times next year’s earnings. Meanwhile, Ford (NYSE: F) trades at about 8 times earnings and is almost certain to make money in the long run.

Stories can clearly affect the stock market as a whole. They can even affect the economy. The Nobel Prize-winning economist Robert Shiller recently drew attention to the economic impacts of stories with his book “Narrative Economics.”

In his book, Shiller explains:

Narratives “go viral” and spread far, even worldwide, with economic impact. The 1920-21 Depression, the Great Depression of the 1930s, the so-called “Great Recession” of 2007-9 and the contentious political-economic situation of today, are considered as the results of the popular narratives of their respective times.

Narratives become self-reinforcing, displaying what billionaire investor George Soros calls “reflexivity”. Soros noted that traders make decisions that change the state of the market, and the market moves in response to those collective decisions. Market moves then provide new information, and the trader then makes new decisions that were, in part, required because of the impacts of the original decision.

The market is always responding to a story and in a state of reflexivity. But we could see this process accelerate in the weeks ahead.

Strap In, Folks

The chart below shows that the S&P 500 Index has been responding to the coronavirus narrative.

Now, reflexivity will drive the market.

If the coronavirus story becomes more panicked, the stock market will decline. As it declines, it will break support, and that will trigger technical selling. That selloff leaves the market vulnerable to rumors and misinterpretation of news.

In other words, now is a time to consider how bad it can get. We can use that information to decide how defensive to be in our own portfolio. Support is near 3,100, as the chart below shows. The rectangle shows an important area of support.

If prices fall through support, the pattern projects a target that’s about 8% below recent prices and a little more than 10% below the recent high.

It is possible that after a 10% decline, investors will be prone to sell further as they worry about a bear market. That could push prices down further. In effect, the fear of a bear market contributes to the likelihood of a bear market.

Now, it’s always true that a fear of a decline can contribute to a decline. The risk of investors acting on that fear is highest when the narrative is negative.

But a negative tone has become almost standard over the past few years. Many blame President Trump for a negative tone in the country. But there was a group of voters opposed to President Obama, and, before that, a large group opposed President Bush. Negative narratives are the rule in political news, no matter which party is in the White House.

It generally takes a negative global event in a time of economic weakness to shift sentiment. Coronavirus is a negative event. The economy is growing slowly in what has become a “new normal” era of slow growth with low interest rates almost eliminating options for safe income.

Action To Take

The risk of a 10% pullback in the stock market is high. So is the risk of a bear market. Given these higher-than-average risks, now is the time to consider how you will manage your portfolio in a declining market.

You could act now, or wait for a break below 2,970, the important level shown on the chart. You could sell all stocks or simply reduce exposure. The choice is a personal one.

I will be trading the market opportunities that develop in this environment. That will include buying put options at times. I will also add call options to manage risk and benefit from the bounces that occur. And I’ll generate income by selling puts in stocks that meet my requirements for safety.

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