Note: Considering the potential market fluctuations throughout the COVID-19 Pandemic, it should be noted this article was originally written on 4 April 2020.
These are unprecedented times. Shamefully, the biggest thing I first noticed was the lack of a long commute to work. It went from 80 minutes to 25 to 0, which was actually quite nice. Then I noticed how sad the cereal aisle looked. This is essentially the only place I’m allowed to go now. All kidding aside, I, and probably most of us, fail to appreciate the full gravity of the pandemic at this point, and how it will affect the decades to come. It’s a difficult thing to do in the moment; events of this magnitude usually need retrospect to understand their full effect.
Starting on Feb. 20, the market went through essentially the most volatile four-week period in the history of trading. I remember leaving for the British Virgin Islands on a sailing trip on March 8, thinking the downturn had finally come to an end. I was wrong. I’ve worked in trading roughly the past eight years, a relatively short time, but also a relatively stable one. My boss used to tell me how countless fund managers didn’t know anything during that period; beta (general ETF index funds) was crushing alpha (hedge funds managers) in annual portfolio returns, consistently. Volatility was exceptionally low and the stock market was steadily increasing. You didn’t really need to be a “stock-picker” back then, you just had to invest in stocks, he’d say. That time has changed.
In my last article I mentioned how I thought the demand-side shock (social distancing) was still currently undervalued in the market at the time, and if COVID-19 progressed into a true pandemic, another 10% drop in stocks was almost guaranteed. I suppose I was right in direction. I was not in magnitude. I would never have contemplated another 20% drop in stocks, but that’s what happened. The S&P fell 30% from peak to trough, wiping out two years of returns in less than one month. The volatility was insane. You have probably heard of the VIXX at some point by now. It’s called the “fear gauge” on the street. Basically, whenever it is high, the stock market is probably getting crushed. Since 2000, the index has had a mean of about 19.36, and in March it hit 83.08. That’s more than 4 times the average!
One more trading statistic I want to highlight, just to paint the full picture of how historically insane this period was, and then I will try to stop boring you with the technicals. After the Oct. 19, 1987 stock market crash, in which the Dow plunged 22.6% in one day, the SEC mandated circuit-breakers in all U.S. exchanges. In theory, these circuit breakers literally just turn the power button off on trading for 15 minutes. I find this behavioral finance element of trading fascinating. Essentially, we give investors and traders (humans) 15 minutes to calm down and get their you-know-what together. We then decide if they really want to sell or are just panic selling, before we give them the capability to do so again. The circuit breakers on the S&P 500 are benchmarked on percentage shifts; at 7% down the first circuit breaker kicks in, then another if 13% down, and if the market goes down 20% in one day, trading is halted for the rest of the day, period. Since 1987, a breaker has only been triggered once — in 1997. The breaker wasn’t even triggered during the 2007-09 financial crisis. But the circuit breakers were tripped four times this March (9th, 12th, 16th, and 18th). A fun fact if you are wondering: there are no circuit breakers in the opposite direction.
More on my (now-retired) boss. His name is Duncan. What a great goddamn name. Seriously. When he called people on the phone, he never had to say his last name. Just “Hey. It’s Duncan.” And he’d be on his way talking about how municipal bond spreads are trading at a premium based on current tax ratios. Everyone just knew the power of that name and immediately, who it was.
One of Duncan’s spiels whenever the market tanked was:
“There’s no bid! What can you do? THERE’S NO BID! You see this screen? NO BID!”
What Duncan was trying to say is when the market crashes, it’s obviously because the price went down. And the price went down because even at successively lower prices, no one wanted to buy.. aka.. there was no bid! Stocks have value based on company fundamentals, for sure, but for a stock to have a transfer price there must be two parties: a separate buyer and seller. And if everyone is a seller, prices fall off the cliff before you find a willing buyer. That’s why It’s called a sell-off.
Stocks were not the only security that took a massive hit. Every asset was aggressively sold in this market. Nothing held its value, not stocks, not gold, not fixed income, and no, not even bitcoin. Normal correlations did not hold, a term in finance coined dislocation. In other words, the normal offset a fixed income portion might provide your portfolio when stocks go down did not hold in March. In this type of violent, high-velocity sell-off, cash is not only king. It’s the only thing that matters, and the general market is likely suffering from illiquidity.
Liquidity is a somewhat obscure word given how many people (even in finance) do not actually understand what it means. Yes, it can mean simply “convertible to cash,” but it also implies that assets can be purchased and sold at or close to fair value with many distinct buyers and sellers. If bond (aka debt) markets are illiquid, there is limited transfer of capital, which inhibits not just growth but even just maintaining a business. This usually precedes and coincides with significant widening in credit spreads. In other words, bond investors require not just a higher rate, but, more importantly, probability of return for the same amount of money one might want to borrow. Uninhibited in the current market context, this would eventually lead to mass bankruptcies as firms that cannot raise cash, and have no revenue due to economic shutdown, default on their existing debt and are forced to liquidate.
I wanted to properly explain the mechanics of this market sell-off for two reasons. First, to frame the conversation of how the Fed has stepped in, and boy has it stepped in. In my last article I mentioned how the fed had made an emergency 50-basis-point cut in short term rates, which was the only thing it did before I left for that spectacular sailing trip I should have stayed on:
“If the worst outcome materializes (a true pandemic), what does it matter how high short term rates are? The move was really only made to affect investor sentiment…”
Answer Fed: Insert 1.5 Trillion dollars here.
This initial trillion dollar injection was targeted at the repo market (otherwise known as repurchase agreements). Repos are one of the biggest ways Wall Street raises cash. Imagine you own an asset, like a treasury bond, that’s worth $100k. Now assume you have immediate cash needs for $100k, but you don’t have any actual cash on hand. You can enter into a repurchase agreement, where you sell the treasury bond to someone, and within the same contract agree to buy it back from them in, say, one month at a predetermined price. This is better than outright selling the asset due to certain tax implications, among other factors. In this scenario, you get the cash you need and don’t permanently lose the assets you already own. You just temporarily monetized them. Repos were suffering from severe illiquidity in March. Everyone was looking to hoard cash, so even if you had an asset of value, no one would buy it. Access to capital markets (a.k.a. debt raising) became scarce. The fed came in to agree to accept assets (in the fed’s case, usually treasury securities) and give you cash back. For the Fed this is usually just with other U.S. banks, so that those banks can circulate the cash received into the economy and ease the illiquidity. The last thing of importance I want to mention here is the Fed did not bail anyone out. The fed never bails anyone out. It is a lender of last resort, it never does anything for free. Any loans to banks from the fed are always overcollateralized, meaning if a bank borrowed from the fed and defaulted, it would actually lose more money than if they just paid off the loan.
The fed also sent short term rates to near zero, encouraged U.S. banks to borrow more from it, using the discount window facility, started quantitative easing again (pushing down longer term U.S. treasury rates like 10-year terms to ease the cost of borrowing), and created or reintroduced five new credit facilities focusing on different asset classes, from securitized loans to direct purchases of corporate bonds, etc. It even added another facility for other central banks to utilize to ease the stress on the U.S. dollar. Powell basically emptied his clip. Instead of just giving banks access to cash to reverberate in the economy in exchange for treasury bonds, it also started buying directly from corporations, municipalities, etc., to further expand its reach. The Fed effectively became not only the lender of last resort, but with the new credit facilities, really a buyer of last resort. By buying when no one else wants to, the Fed basically acts as a stopgap of illiquidity. Back to the Duncan no bid example, a magical bid finally appears, with trillions.
The reason for the market turmoil here was an exogenous one, which is rare. COVID-19 and associated social distancing resulted in a 30% decline in stocks, basically immediately. The labor market is even worse, if possible. Last week there were 3.3 million initial claims, about 5 times the peak of the financial crisis. This week there was an additional 6.6 million. That’s nearly 10 million jobless claims in the last two weeks alone. This is an order of magnitude larger than the financial crisis.
The second reason I broke out the mechanics of this self-off is to explain why a claim I made about mortgage rates in the last article turned out to be patently wrong. It was correct that U.S. Treasury rates fell to their lowest point in history. But mortgage rates, and essentially every other interest rate for that matter, consist of two primary components: 1) The Risk-Free Rate (U.S. treasuries) and more importantly here, 2) a credit spread. When a company issues debt, it is commonly benchmarked this way. For example Apple might have been able to issue debt at 10-year Treasury Yield + 200 basis points before the market tanked. But when businesses have no revenue because the economy has been shut down and 10,000,000 people lose their job in a span of weeks, investors get scared that debtors might not be able to pay them back, even Apple. Some of those 10,000,000 people were expected to buy an iphone in the next year and now cannot. So for Apple to borrow money, investors might need 400 basis points (as opposed to the original 200) over the 10-year treasury to compensate them for this new risk. The magnitude of the decrease in risk-free rates is markedly lower than the increase in credit spreads. This same concept remains with individual mortgage rates. So mortgage rates did not fall as I predicted, even though U.S. treasury yields did. Any debt instrument, regardless of borrower, is predicated on the ability to pay back. This is why you will commonly hear debt markets also referenced as credit markets.
So 10,000,000 people just lost their job, the stock market fell 30%, credit spreads are widening across the board, oil fell off a cliff… You might be wondering, “Are we heading for recession?”
Newsflash: We are in the recession already, if you didn’t notice.
The question is basically agitating at this point. To be fair, I can concede that the word “recession” has some future connotation to it. Whenever we’ve heard it previously, it’s usually forward-looking. For example, some analysts with foresight saw the subprime mortgage crisis coming. Over-leveraged individuals seemed likely to default on their loans, which is going to default all the mortgage backed securities, which is going to cripple the banks. It’s going to take place over the next year or so and then we’ll see a recession. This is why the distinction of exogenous versus endogenous is important. With issues within the system, you can see signals of weakness and make subsequent predictions. Exogenous events affecting the market create uncertainty, and uncertainty is the worst thing to have in the stock market. Uncertainty here isn’t synonymous with risk. Uncertainty here literally means we don’t know how this will pan out. Give the market bad news framed within the system, it will price it accordingly. Give the market something they can’t predict, and you get armageddon.
The question is not are we in a recession, it’s how long will this recession last? All the ammo the Fed could ever have will not truly help unless we tackle the virus itself. Powell is lessening the blow and putting the economy in the most advantageous place to come out of this as strong as possible, but the virus must be contained first, for any of this to work. To that end, please do your part following social distancing and responsibly care for your friends and neighbors. We are in this together, both as a health and economic crisis.
The good news is we know what to do.
Disclosure: This article is for informational purposes only. The Stern Opportunity is not rendering or offering to render personalized investment advice or financial planning advice. Investing involves the risk of loss and investors should be prepared to bear potential losses. No portion of this article is to be construed as a solicitation to buy or sell a security or the provision of personalized investment, tax or legal advice. Certain information contained in this presentation is derived from sources that the author believes to be reliable. However, The Stern Opportunity does not guarantee the accuracy or timeliness of such information and assumes no liability for any resulting damages.