Will equity markets ever roll over again?
Published on: April 15, 2020 • Duration: 17 minutes
This week we look at whether the rally in the equity market is forming a fabled V shaped recovery, which is rare throughout history, but one that is now increasingly becoming a consensus view. Or are people simply extrapolating the magnitude of the recovery, which is itself a function of the size and speed of last month’s sell off?
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Last week's rally was one of the biggest in decades for U.S. equities, and many analysts have been revising higher their outlook for both economic recovery and equity performance. But what's the basis for this reappraisal, and is it realistic? Well, that's The Big Conversation. In many ways, the narrative over the last week or two has caught up with the markets, in that we had that shocking early period in the markets, which I define really as being first an economic shock and then a deleveraging shock. And that deleveraging shock was so severe that it felt that the markets were way ahead of the actual narrative on the virus itself. Well, it feels that that narrative has now caught up. We've probably seen peak fear certainly in parts of Europe, if not most of Europe and the US. Peak fear is probably behind us, and peak fear normally comes fairly close to at least a short term low in the market. But is that peak reality? What I mean by peak reality is that the reality of how economies are going to recover and therefore how markets should actually be behaving coming out of this first initial low. And the way a lot of people are thinking about the market itself, is their thinking about, should we roll over and immediately retest? Well, maybe that immediacy is now gone. We haven't immediately retested those lows, but should we retest those lows sooner rather than later? As in the next couple of weeks? Or should it be something that happens later in the year? Where as many people are now thinking maybe there should be no retest at all, that we actually have a V-shaped recovery in the equity and risk markets. And can that be commensurate with a V-shaped recovery in the economy? Obviously, a lot of this depends on the talk of reopening economies. We've already seen many of the early adopters of very aggressive responses are now actually going back into re-closing down or closing back down their economies. We're seeing problems in Russia reappear. We're seeing it in Singapore where they're locked down to at least early part of May. And they're even talking about not opening their borders for an extended period of time. And in parts of China, there was a recurrence of the virus. Is this going to be a one wave virus, or like Spanish flu or is it going to come in multiple waves, which therefore means that the reality of opening up to the sort of level that we saw before is highly unlikely. And that's what's going to define the cashflows, it's what's going to define how economies and how particularly corporate balance sheets will progress from here. So where does this optimism come from? Well, a lot of it has to do with the enormous amount of stimulus that we've been seeing from central banks. We've been seeing it globaly, we've seen it in Japan, Europe, and obviously particularly in the US, where it seems the FED is doubling down and then doubling down again almost every week. Last week they announced yet another stimulus package. I mean, they've already added about 1.8 trillion to their balance sheet over the last four or five weeks now. To put that in perspective, between 2009 and 2014, they added around about 3.7 trillion. So in five years, they did roughly double, just slightly more than double what they've done in the last five weeks. And some people are saying the FED will do QE infinity, which is they will continue on doing this until everything has recovered. But what was notable last week is that they focused on the lower end of the corporate bond market. They're already targeted investment grade. And in fact, the LQD ETF, which is the investment or one of the investment grade ETFs, that's actually up year to date. So it's showing actually an improvement from where it was in January. And the high yield ETFs such as HYG, have also had a very, very impressive performance over the last few days. And although HYG is below the level it opened this year, it still had one of the most impressive recoveries. And this has left many people thinking, well, the next stop could be buying equity. Now, they're not supposed to, but we've seen in Japan that they buy equities. So people are saying, well, why would I want to be short equity when it looks like they will buy absolutely anything. So I think this is one of the key elements, and the size of the stimulus is huge and the speed is also unprecedented when we look at any other period in history. But in some ways, it's still much, much smaller than the overall shock to the economy. This isn't really a stimulus, this is stabilizing the declines that we've seen. It's papering over the cracks. It's providing some support. And whether they'll actually target more than just the fallen angels, such as the likes of Ford, who dropped out of the low end of investment grade on the 24th of March, and this new scheme was backdated to the 22nd of March. So clearly they're trying to pick up some of these fallen angels. Whether they'll aim for more than those, the really bad end of the market is uncertain. They probably shouldn't. But currently it's being given the benefit of the doubt that this blunderbuss, scattergun approach will impact all parts of the market. So in some ways, this is why I think people are looking for some of the V-shaped recovery is that the size of the monetary package, plus the fiscal packages that are coming are seen as being sufficient to offset the crisis that is still unfolding. But it's worth putting all of this into some context in terms of the bounce that we've had. The bounce has been roughly 20 percent so far, so some people are saying it's a new bull market. But as we talked about last week, we have to put this in context of the size of the drawdown. So from peak to trough, the S&P fell 35 percent in a very, very short period of time. It's the fastest drawdown that we've ever seen from an all time high. So this bounce that we've had is nothing out of the ordinary, in fact, it's very run of the mill in terms of 50 percent retracement of that initial selloff. We can put this in context - between 2015 and today, we've had including the current one, five reasonably major pullbacks. 2015, it was the China mini devaluation in August. The market sold off, rebounded between 50 and 62 percent and then retested the low. In 2016 we had an economic shock coming through the market - it was the end of the dollar crisis, the end of the earnings recession. Market sold off, I think it was about 15 percent. It rebounded around about 50 to 62 percent. But again, we tested the lows, didn't break through the lows, but we tested the lows. Volmageddon early 2018, this was the shock of the vol blow up, the shortfall positions blow up. The market sold off in a straight line very quickly, rebounded actually on that occasion 76 percent, and then had a retest of the lows but didn't break. And even in 2018, one of the reasons people think of a V-shaped shape recovery today is because after December the 24th, the low was set and then we bounced out with a V. But on the way down there, we actually had at a sell off into November ish, then a rebound of around 50 percent, and then a retest and a break of those lows before we had that final low, and then the Fed relented and the market started to recover. So to get a 50 percent retracement is not unusual. It happened in Japan in 1989. Numerous times it would sell off, rebound about 50 percent, resell off again, rebound 50 percent. Same thing happened in 1987, it was a 38 percent retracement. And these numbers are with Fibonacci's 38, 50, 62. These are the big ones. You expect to rebound to at least 38, 50 and quite often 62 percent. And that keeps the actual downtrend intact, but it can then roll over. So we haven't even hit 62 percent today. And it can even go back to 1929. And back then we had similar sorts of bounces. The point being is that don't focus on the size of the bounce from which people are extrapolating forward, that the economy is better off. Think of this in terms of the rebound of the selloff. Currently it's 50 percent, it could be 62. Once we are above 62, then we can start thinking about the all time highs based on this Fed stimulus. But until then, we're still very much in play of a bear market bounce, and we shouldn't take it as being any more than that just because we bounced 20 percent off the lows. So that's the context. And I think it's a very, very key context to understand this framework of the market, because this could simply be oversold because we have this deleveraging rebound and then reality kicks in. And also within this context what's very important for people to understand, is the difference between a blow up in the framework of the market and an economic crisis. In 2015 the market structure blew up, after the mini devaluation and risk parity funds unwound. And we saw this because volatility of volatility, we don't need to know much more than that but it's just options on volatility. The vol there exploded high, it was a record move at that stage. But in 2016, at the end of that dollar crisis and the earnings recession, we saw an equal sized selloff in the market. But volatility of volatility bounced nowhere near as hard. In 2018 with volmageddon, we saw a big bounce in vol of vol. So that was a market structure issue. But at the end of 2018, where we saw that worry about a slowdown and then the FED mistake by raising rates at the wrong time, that was an economic issue. Volatility of volatility did not behave badly at all. Roll on to today. And initially, volatility of volatility did not move aggressively. This was an economic shock, not a market structure shock. But then volatility of volatility moved aggressively. This became both an economic shock and the market structure shock. Whilst we can rationalize market structure shocks once they've completed their deleveraging, it's much harder to rationalise, at least understand how long this economic shock can go on. And I think that's where the reality will kick in later. So I think that's something so very much clearly bear in mind. And that brings us on to the impact on the real world, which can be very different from the impacts on financial assets, which can have these short, sharp hits positively or negatively, from flows in liquidity. And what we can see in the oil price is that although we obviously had that massive collapse earlier this year, and now we've had a very significant response from OPEC +. As of this morning, which is April, Monday, April the 14th, the oil price has only been up a few percent. And in fact, it's nowhere near the highs that were achieved after that initial shock, surprise announcement that there were going to be cuts coming. The oil market is still driven by real demand, is still an oil glut out there, and there is still a shocking outage of demand. So these cuts probably on big enough yet. And we can also see things like US high yield energy sector, this is the corporate sector. Whereas the overall high yields area has had a reasonable recovery, in the high yield energy space the recovery is very, very minimal so far. In fact, it's massively underperformed that of the rest of the market. So oil and oil associated sectors are still struggling somewhat with the real economy slowdown. And this can also be seen in the US dollar. The US dollar itself, it's off the highs, but incredibly, in some ways, given all that's been thrown at it, this incredible amount of stimulus stabilization, liquidity with this new 2.3 trillion announced last week. So the expectations that this QE infinity and yet the US dollar is only down slightly off its highs versus things like the Euro and is only very marginally down, in fact continues to try and strengthen against most of EMFX. When we look at the JP Morgan FX index we talked about before, that's still near its lows with a low its dollar strength EMFX weakness. So we can still see that the real economy outside of the US, and it is the economy outside of the US that is desperate for dollars. This is the euro dollar system. This is the world that transacts in dollars. It does its invoices in dollars. It buys its raw commodities in dollars. It buys its goods in dollars. If the volumes of transactions have fallen and everybody's hoarding dollars because they're worried about defaults and therefore solvency in the future, then that euro-dollar system is short of dollars. And there's also that record level of dollar debts. And recently, I think Rabobank suggested that the euro dollar system, this is the outside of U.S. system, has around about fifty seven trillion dollars in its various liabilities, assets, etc., which clearly dwarfs the liquidity that we're seeing being suggested by the US Federal Reserve. We can also see if the rest the world was recovering, then things like the ratio of the S&P vs. MSCI emerging market should show some strength towards the emerging markets. And again, that's not really happening. It's the S&P, it's the US that's really benefiting here. And maybe that's one of the reasons why the dollar's not weak is that so far the focus has been on US financial assets, there's allegedly going to be into the US real economy, but that's going to have a big lag. And so maybe people are rewarding the US for being the first mover when the ECB and the Bank of Japan are certainly lagging. We can also see it in yields as well. If we look at yields, the US 10 year yield ran about 75, 74 basis points this morning. People are talking about yield curve control, yield curve caps where through QE the central banks will hold yields down. Now that might be distorting the yield curve, but it could also be that yields are low because there is a desperate demand for safety. And US 10 year yields or U.S. 10 year bonds provide certain safety in an economy that is still under a lot of pressure. And again, these are yields which remain very, very low, despite the fact that a lot of foreign entities have been selling treasuries in order to raise dollars. And one of the reasons why the FED put these repo lines in places, that were they were worried that the foreign entities were selling treasuries, there was no bid in treasuries, causing a problem with the Treasury market and yields obviously spiked above 100 basis points on the 10-Year. Now, the threat of a yield curve control, plus these repo lines in place means that the yields themselves look like they may be staying around about this hundred or under 100 basis points and maybe they're ultimately headed back towards zero as the real economy kicks in. And on that front, we can also see some of the companies that have provided mortgages have not yet recovered in any way, shape or form compared to the broader market. This is the real economy. And although mortgage prices themselves may not be particularly aggressive because obviously the overall level of yields have come down, delinquencies are expected to increase, so people who have provided mortgages are under pressure. The point here is that the real economy in the US, in Europe and the rest of the world is in a very, very difficult position. So how do we put this all together and try to work out whether what we're seeing currently in risk markets, particularly equities, is still just a bounce from an oversold position, or whether it's the real beginnings of a true recovery to maybe the all time highs? Well, we've got earnings coming out. Earnings and sales are pretty meaningless, but we might get some insights into corporate balance sheets and whether they're impaired before the virus hit. Now, obviously, we have to then temper that with the reality that central banks such as the FED are now in to support those markets. At the moment, the market itself, the equity market and the corporate bond market has kind of treated it as a scattergun approach. So they're going to buy everything. But they have said that they're going to buy specific companies, the fallen angels and the likes. And this should mean that certain companies are going to fall back over again. The moral hazard is clearly there. The lack of price discovery is a problem. And the fact that the FED has been so involved in both investment grade and now what was thought to be sacrosanct, which is not getting involved in the junk market, but they have. Some people, as I said before, could extrapolate that out to them getting involved in the equity market. It's a concern, particularly with QE infinity, but I think there's a massive lag between what they announce and what they actually do, particularly on the fiscal side. The reality is that these economies globally, were turned off like a light switch being turned off. They're not gonna be turned on by flicking the switch back up. They're gonna be turned on slowly as if the dimmer switch is being turned up. And every now and again it's gonna be turned back again. Companies and corporates and countries, when they do come back on line, they will come back on line in a piecemeal fashion. They might go back off line again, as we're seeing in places like Singapore. Supply chains will be disrupted for an extended period of time. Cash flows will be disrupted for an extended period of time. And finally, going back to the context of those Fibonacci retracements, which not a lot of people necessarily like, but it gives a very good context. This bounce so far at 50 percent is a perfectly normal equity bounce in a normal bear market. It could get to 62 percent, and sometimes they even get higher than that. 62 percent would be around about 3000. We can re-evaluate it when it gets to 3000. I myself wouldn't actually want to buy this market apart from on a trading view, someone who is watching the markets all day, every day could trade these markets. But on an investment view, I'd be happy to see if the unthinkable, which is that central banks and their liquidity along with the fiscal stimulus can support markets forever. I'd like to see them make new all time highs before I go all in again. Until then, this still looks and feels like a very aggressive bear market bounce. The danger being that is, more and more economists and more more strategies start saying the lows are in, that increases the risk that we roll over sometime through the summer and make new lows towards the second half of this year.