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
I agree with your assessment regarding the mispricing of systematic risk. Economic conditions have not been this bad in decades. The economy is much worse today than in 2008 during the great recession, when the issues were mostly centered on bad loans, derivatives and excess leverage. The S&P 500 fell about 56% during that bear market. Valuations for the 500 Index were lower back then compared to the peak this year.
The Federal Reserve has done all it can do to help the economy by dropping the fed funds target to 0 and by announcing plans to purchase large amounts of various debt securities, including junk bonds. On the fiscal side, congress has approved a very large spending program to prevent the economy from collapsing.
I do not know where the markets are headed but I am confident, we are not going to see a V or U shaped recovery, as getting the economy back on track is not going to be as simple as flipping on a light switch. The recovery is likely to be very slow until we have a vaccine. Most people are not going to feel comfortable going to places with large groups of people a for a while and this sentiment will have a negative impact on many industries.