By Pete Biebel, Senior Vice PresidentPrint This Post
Goodness gracious! Again last week, the market shook our nerves and it rattled our brains. That market action can drive a man insane. Last week was the first since late-1929 in which all five trading sessions had a gain or loss of more than 4%. Three of those days included trading halts early in the session. Don’t let it break your will. It was another week of thrill-ride volatility that seems to have been inspired largely by dramatically worsening Covid-19 news, but which was violently exacerbated by the sudden urgency to close out positions and reduce risk in mechanical trading systems. In other words, much of last week’s selling was not based on fundamental value.
An old adage among portfolio managers is, “in a panic, all correlations go to +1.00.” Under normal market conditions, the various asset classes all have their own peculiar natures. They don’t normally all move the same way or by the same amount. Knowing, for example, that bonds usually have a very low or even negative correlation with stocks, portfolio managers look for a combination of asset classes that provides a smoother ride over the long-term. Last week brought panic, and everything sold off. Tech stocks, utilities, Treasuries, muni bonds, junk bonds, even gold and crude oil all hit the skids. If there’s good news in that development, it’s that such episodes usually don’t last very long. High inter- market correlations should begin to revert to more normal interactions in just the next week or two.
Much of the Wednesday/Thursday selling was forced selling by risk parity funds. They’ve been all the rage in recent years. These funds seek to continually allocate to the basket of asset classes in the appropriate size that promises the best risk-adjusted return. Over time they will increase the position size of an asset class that was experiencing lower volatility. Likewise, if a particular asset class suddenly experiences much higher volatility, the portfolio is compelled to reduce its size therein. And that means now! Stat! Schnell! No questions asked. The appropriate portion of that asset class’s position is immediately sold at whatever price it can fetch at the time. Such funds, trapped in a world where suddenly everything was selling off (i.e. all correlations went to +1.00) and where volatility levels across the board spiked higher, were forced to liquidate positions in many asset classes regardless of price. And, yes, when volatility subsides, they’ll be buying back many of those liquidated positions.
A similarly affected group were market-making firms. The ongoing current positions held by these companies is constantly monitored by their clearing firms. The clearing firms often use a metric called Value-at-Risk (VAR) to make sure the clearing firms’ current holdings are well within their comfort zone. A key ingredient in VAR is the actual volatility of the various assets. When volatility increases, VAR increases. Imagine what happens to a market-maker firm’s value-at-risk when the volatility of everything spikes higher. To get VAR back to an acceptable level, an offending firm would be compelled to close out some of its current positions that day and to do so regardless of value. As long as volatility remains elevated, those market-making firms will be limited to smaller than normal positions and less than normal activity. So, this is another phenomenon through which elevated market volatility leads to reduced market liquidity and diminished market depth.
And, as previously noted, volatility begets thin markets which in turn beget more volatility. This too will pass.
Last week I repeated several paragraphs from the prior week’s comments including this one:
“And, while there’s no telling when or at what level a bottom will be formed, it will likely include some distinctive technical features. It may very well come on a capitulation inspired shake-out with convulsive, blood-in-the-streets panic selling. It will likely occur on a day with much higher than normal volume. It wouldn’t be a surprise if it came on a day with steep losses early in the session that reverse to end the day with a gain. And, the low will probably be very near a key technical level. In the 2018 wash-out, SPX bottomed within a few points of its 200-week moving average. Currently that average stands in the mid-2600s, about 10% below Friday’s close. Let’s hope we don’t have to see a replay of that feat.”
What a thrill! All those technical features were evident late last week. Wednesday and Thursday were the blood-in-the- streets days. Following Wednesday’s new low close for the week at SPX 2741, traders might have been hoping for a chance to buy near that 200-week moving average at 2640. But on Thursday morning, SPX gapped below that level, opening near 2630, and closed at its low for the day near 2480. Trading volumes on both days were among the highest non-expiration-day totals in years. Stock index futures dropped to even lower levels in overnight trading only to reverse Friday morning and trade in the plus-column all day. The piece de resistance came in the final fifteen minutes of trading when SPX vaulted from 2600, blew through the 2640 moving average and closed near 2711. Goodness gracious indeed!
That’s a long-winded way of suggesting that last week’s action has a chance to have produced a good short-term low. For that to be the case, it would be best for the markets to immediately extend Friday’s rally when trading resumes on Monday.
The probability that the averages made a good long-term low last week is maybe 20% at best. And, if last week is going to be the low, then we would need to see improving news on the pandemic soon. In other words, in my estimation, we should assume for now that the odds of at least one lower low are about 5-to-1. Over the years, some of the most impressive short-term rallies have been rebound attempts in continuing bear markets. The averages need to rally powerfully enough and long enough to make us believe that a new uptrend has begun. If we see continuation of the Friday rebound in the coming days, then SPX could easily climb into the low 2800s. A 50% retracement, similar to what SPX enjoyed in the previous week, would lift the index to about 2930. The absolute best I expect at this point is a rebound to the 3025 area. That level is roughly the highs of last summer and the 200-day moving average. My plan will be to reduce positions in anything that I wish I had sold three weeks ago if SPX gets into the upper-2900s.
My guess is there’s about a 60% probability that the averages will eventually fall below last week’s low by something between 0% and 5%. If that’s the worse it gets, then SPX should hold above its December 2018 low. But that still leaves about a 20% chance that the averages eventually drop below last week’s lows by more than 5%.
The depth of the economic damage caused by coronavirus is currently unknown but based on the extent of the markdown to date and the impact of the forced selling noted above, I think we can confidently conclude that some stocks, perhaps many stocks have already seen their prices fall to levels that represent good long-term fundamental value.
Last week I pointed to one index that was already a cause for concern, the Russell 2000 Index of small-cap stocks (RUT). Its recent skid has been much steeper than that of COMP or SPX. In the previous week, RUT dropped below its 200- week moving average and below its lows of last summer. RUT ended that week about 11% above its December 2018 low near 1300. I guessed then that if it lost much more ground in the coming week, it would greatly increase the odds that the old low could be tested in the near future. RUT not only fell below that December2018 low on Wednesday, but also, on Thursday, fell to its lowest level in nearly four years. In just the past three weeks, that index has had a larger loss, in points and as a percentage, than it lost in its steep four-month slide in late-2018.
For the week, COMP, DJIA and SPX all had net losses of 8% to 10% or so. RUT fell nearly 17%. My earlier statement that some if not many stocks may have already fallen to price levels that represent good long-term fundamental value, also applies to some of the small cap stocks that are included in RUT. However, because the group’s downward momentum is so extremely negative, and because most small-cap stocks offer far less liquidity than their larger brethren, trying to call a bottom in a small cap stock is a much riskier venture than in less volatile, more liquid big cap names.
You may be afraid to look at your 401K balance, but it might be worth taking a peak for a couple reasons. One is that you’ll probably see that you’re back to about where you were a year ago. So far, we’ve just given back some of the “house money.” Stocks, in general, had a great run for ten years and 11 ½ months. So, while we all gave back a big chunk of the recent gains, on a long-term basis we’re still in pretty good shape. A second reason is to review your current allocations. Given the recent moves in the various markets, at some point, it might make sense to lighten up on bond and bond-like allocations and redirect that money to increase equity exposure now that stocks seem to be on sale. Now is the time to consider under what conditions and to what degree you might take such actions. Take some time to talk to your advisor.
Our economy is probably already in a recession. GDP will probably be determined to have declined slightly in the first quarter. On Sunday afternoon, it was reported that the investment banking firm, Goldman Sachs, revised their estimate of second quarter GDP to -5%. That would be the largest quarterly contraction since the financial crisis twelve years ago. There’s little doubt that GDP will decline to some extent in the second quarter. That means that if first-quarter GDP declines at all, then the economy will most likely be officially recognized to be in recession when the second- quarter numbers are released. If the first-quarter can squeak by with even a small increase in GDP, then a dramatic recovery in the third-quarter could avoid an official recession.
Each day there will be more headlines revealing the new and unexpected ways in which the pandemic is hurting our economy. On Sunday afternoon, the Governor of Illinois ordered all bars and restaurants in the state to close. Goodness gracious! That means that bars in Chicago will be closed on St. Patrick’s Day!
In the coming weeks, the market will be weighing whether the proposed fiscal support actions will be sufficient to slow the decline in economic activity. Following on their massive liquidity injection last week, the Fed announced several significant emergency easing measures on Sunday. The Fed cut their key rate to 0%, announced $700 billion in new quantitative easing and cut their rate on overnight index swaps to 0.25% from 0.50%. In spite of the Fed’s actions on Sunday afternoon, stock index futures were all trading about 4 ½% lower when trading resumed that evening. If that’s still the case on Monday morning, then it would greatly reduce the possibility of a short-term low. Goodness gracious indeed!
|Tuesday 3/17/2020||Retail Sales, M/M||104.3||+0.1%|
|Retail Sales, ex-Food & Energy, M/M||+0.1%|
|Industrial Production, M/M||+0.4%|
|Wednesday 3/18/2020||Housing Starts, SAAR||150K|
|Thursday 3/19/2020||Initial Jobless Claims||220K|
|FOMC Policy Announcement and Press Conference|
|First Quadruple Witching Expiration of 2020|
Links to previously published commentaries can be found at benjaminfedwards.com/For Our Clients/Educational Resources/Market.