tldr: unprecedented mismatch between reality and the market's expectation for volatility, I give my macro view on why I think that's happening. Would like to hear what others are making of all this - not interested in forecasting, I think trying to understand the current environment is more important.
Alright, it's another weekend indoors that I've spent trying to make sense of US equity markets - I still have no clue where things will go from here. No one knows, and I'm not going to make a fool of myself by trying to predict the future.
Instead, I want to start a discussion on why - in my view - this pandemic was, and still is, the biggest mispricing of systemic risk in the history of equity markets.
I'm curious to hear what your views are, especially the bulls out there - I'm more than happy to be wrong about all this, you guys always give me a bit of hope.
As I'm writing this the Vix last printed 46.8, in other words, that's the market telling you that the Spx is expected to trade in a range of +/- 46.8% over 1 year, 68% of the time (representing 1 standard deviation). That's a price range of 1324-3654 with a 68% probability of being true. The Vix alone doesn't prove much and yes it has it's limitations, but it does highlight the level of uncertainty in the market - uncertainty surrounding what the fair prices should be in the post-virus world.
The recent level of mismatch between reality and what the market was expecting in terms of volatility is unprecedented. If you've looked at the Vix futures market recently you'll know exactly what I mean. On March 3 Vix traded at 33 while March 18 Vix futures settled at 26 i.e markets expected that the Vix would fall 7 points from 33 to 26, it instead printed 70. The market underpriced the volatility by 170% - this rarely happens.
This is why I feel investors are still currently mispricing it; in 8 consecutive trading sessions 2 weeks ago the Spx moved -7.6%, +4.9%, -4.9%, -9.5%, +9.3%, -12%, +6%, -5.2%. Those swings were mostly based on headlines, fears, and investors speculating on the economic damage the global lockdown will cause. We still don't know what the real economic damage is, yet a sizeable majority are still trying to call a bottom and buy the dip.
This isn't about a pandemic, this is about a high consequence, low probability event suddenly shutting down the global economy without an end date in sight, and something no business, government or investor could have predicted or planned for. That should hurt more than the -20% we saw in Q1. I feel the real bear market - one that accurately reflects the underlying economic data and reality - hasn't even started.
3.3m US citizens - 2nd highest on record - filed for unemployment two weeks ago. 6.6m filed last week, that's 2% of the entire US population and the highest on record. For comparison, the number 3 spot was 700k in a week - and that was in 1982. The real economic damage is parabolic and isn't slowing down, that makes me very worried. To reiterate, that's 6.6m jobless claims in a week, not even close to anything in recorded human history, and yet, following the announcement the Spx advanced to its first 3-day rally since February. Perhaps it had to do with the Fed announcing infinity QE and data revealing they printed $60m a minute in the week of March 18-25.
When you lock down a business you not only destroy their sales - everyone else is affected. A cancelled conference doesn't appear to be a big deal when you look at it in isolation, but when you factor in the caterers, advertising agencies, the venue, ubers, etc, fuck, you can see why I'm sceptical. Now let's apply that to almost every restaurant, cafe, casino, airline, small business - practically anything that isn't online, you start seeing reality for what it is.
One major whack to the face is that all of this hit us at the worst possible time - at the peak of a raging bull market and in an election year where the current US political system is a two-party system with high-peaked bimodal electorate preferences. I.e. there are no winning centrist politicians and no stable centrist policies - there are two extremes and the market will look very different depending on which side wins - this creates add to the uncertainty and widens the range of possible outcomes.
SARS, the Spanish Flu, and the Swine Flu could have easily had a similar effect on prices if they hit us in January 2020, but they didn't. The SARS outbreak occurred between 2002-2003 when equity markets were already massively oversold and bottoming out after the tech crash. The Spanish Flu pandemic occurred in 1919 - the last year of World War 1. The Swine Flu broke out in January 2009 - right in the middle of the GFC. The world was already in a dire reality and no global lockdown similar to what we are experiencing was ever implemented. This led to a false sense of safety, which in my opinion, was partially responsible for the mispricing earlier in the quarter - there were countless articles highlighting the minimal effects these 'more deadly' pandemics had on equity markets and why investors have nothing to worry about.
Had we faced off against this with less complacency, more reasonable equity prices, less money in risk parity, higher rates, less debt, less geopolitical risk, and most importantly a Fed that the market trusted to be responsible and act on its own to make the right call, the range of possible market prices (volatility) could have been more favourable. The right call - in my view - would have been to focus on the long term health of the economy, rather than sacrificing that to support short term equity prices, as they did by tapping the money printer a million times per second in one week. But it's too late for that now. The 'Fed put' - in my view - expired worthless on March 3 when the Fed panicked and announced a 50bps emergency rate cut, the largest in more than a decade - yet Spx futures hit limit down immediately.
They can hit the money printer to infinity and beyond but their efforts are futile if the markets believe we fundamentally have the wrong prices. Their tools are useless if the reality - or the perceived reality - we believed in violently collapses, and the market starts believing in a different reality, one where growth can't be created by debt and printing money.
I am interested in hearing the case for this being correctly priced in and bottoming out - this could easily be true, but again, no one knows. It's still interesting to hear why you think that; it's also useful in terms of improving our decision making as we will all have more perspectives to consider going forward before forming our view.
Cheers
Its a good analysis.
I would say I'm more bullish because I have a long term time horizon and stocks should be priced based on their lifetime earnings. The near-term pain only has some impact on that, not enough to justify the 30-50% drops in many great businesses.
Money printing can't generate true economic growth. But it can certainly generate nominal growth to equities. A levered company that survives this and continues into an inflationary world would see its stock price grow dramatically as nominal earnings go up and debt stays fixed.
Thank you for your perspective - I owe you one. I never thought that leverage can be an advantage here because I didn't believe many leveraged companies can weather the storm - thinking about it now, most should be OK if this doesn't go on too long.
Its all about finding that sweet spot! Too levered and there's going to be a problem. No leverage is always safe, but you could miss out on an opportunity to plunder the monetary system.
The average bear market triggered by an event is a 28% fall and lasts less than 18 months. This data stems back to the 1800s. We've already seen a28% fall from the peak in Feb (and have since recovered somewhat).
The bull case * All estimates assume the virus can be brought under control within 3 months as is evidenced by China where domestic business is returning to normality.
Negative economic consequences will be sharp but brief, as the gov. provides huge stimulus in both monetary and fiscal policies i.e. Fed rate at 0%, Fed purchasing corporate debt (something they didn't do in 08) and $2tn stimulus (this is c10% of US entire GDP!).
Banks are less vulnerable vs ‘08. Leverage is a third of what it was back then for banks.
Recovery will see a revival of pent up demand for cinema, holidays, pubs restaurants etc
UNDERLYING CASE: Gov stimulus will keep the economy afloat for the 3 months of pain and we will resume in a V shaped recovery
The bear case
Cases in the US have surpassed both China and Italy, still continuing to rise. Iceland, who have tested everyone, have the highest % of cases. Of those who have tested positive, 50% have shown no symptoms. This implies we are massively underestimating the no. of people who have it but also the mortality rate. Things have to get worse before they get better.
V shaped recovery is too optimistic. Despite stimulus, The unemployment numbers you quote still show unemployment is inevitable and currently the US stands at 4.4% (from 3.5%). It's also interesting to note how wide the estimates are (banks are notoriously bullish): BAML have predicted unemployment could reach 7.5% and the Fed have said unemployment could reach 30%. Companies that are highly leveraged (both operationally and financially) are at huge risk of going bankrupt. Stimulus cannot help a business that is bleeding cash with no revenue.
Stimulus is artificially propping up the economy: what about REAL output? We will have a shortage of food etc soon. Artificial support can only go on for so long.
Conflict between isolation and economic recovery. The quicker we come out of lock down the more likely we are to reduce economic damage. However, this increases chances of continuing the spread of the disease. How will we know when it is truly safe to come out of isolation, especially in the light of:
Testing kits are in a global shortage
Oil: price war between Saudi Arabia & Russia has seen the price of oil fall from $61 per barrel at the end of 2019 to $33 today. This means big losses of oil producing companies. Oil & Gas provides more than 5% of American jobs therefore cuts here could be dramatic.
UNDERLYING CASE: Rising infections & deaths, unbearable strain on healthcare systems, huge job losses, businesses going bankrupt and multiplier effects from that.
While I believe the worst is yet to come in terms of newsflow, one could argue a c30% fall from the peak already priced that in. My impression is that this is closer to an optimistic view than a pessimistic one. The bull case holds some merit and and if history is anything to go by, we'll have recovered in 16 months. However, as you point out, this has hit at the worst possible time and could be the catalyst for something more long term. Worth noting recessions happen approx every 7 years and we were long overdue one based on that, perhaps COVID is the match that lights the fire.
No firm view here because frankly nobody really knows but hopefully gives you some food for thought and a balanced view.
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