I’m going to try to keep this post a little shorter by not getting too deep into the explanations but I wanted to post an update with my thoughts based on what I’m seeing.
Given the weakening economic backdrop, the risk across the board is probably at its highest point right now since 2007/08. The damage done by the drops last week is pretty telling and the probability of a bigger illiquidity event is decently high. In short, this is not a time to be overly aggressive with higher risk investment positions and I have been using the bounce to reduce risk exposure.
If markets continue to get hit in a risk-off fashion, you will want to have your shopping list of longer-term investments ready. When markets get thin, the opportunities created can be REALLY nice – but you need cash/reserves in order to take advantage of them.
Here is a summary of my thoughts lately:
- I think the authorities have done a flat-out terrible job with the risks of COVID-19. The only reason the number of reported cases in the US isn’t higher is because the CDC basically told hospitals to turn people away unless they had a direct tie to China. I don’t know if it was because we simply weren’t prepared or what, but I believe this poses a much larger risk than the stock market is currently pricing. As of the end of February, we had basically only tested 500 people in the country. We supposedly are distributing some 75,000 test kits now so I expect the number of reported cases to rise substantially in the weeks ahead. Given how the virus has spread across the rest of the world, it’s extremely naive to think the US is some anomaly. Other countries are basically showing us what will happen if the virus is spreading across the US – sporting events, schools and business will be shutdown for a few weeks until things calm down and hopefully warmer weather slows the spreading. If that happens, we will lose three percentage points off GDP at a minimum. Could this all be a short-term shock that we bounce back from? Yep. But markets do not care about that in the short-term. They trade off of fear of the unknown and will get hit hard until there is clarity that the situation has bottomed and the pace slows. Is it possible that the US did dodge the bullet? Absolutely. But the upside in that scenario is very limited relative to the potential downside. It’s an asymmetric profile where you are foolish to not be reducing risk exposure on bounces like this week. So, as investors, we need to then be thinking ahead to what the world will look like following a potential shock:
- How will governments respond?
- How will central banks respond?
- Basically, you want to be prepared for a potential shock and then use it as a buying opportunity for the things that will respond best afterwards.
- From a macro perspective, currencies, bonds and commodities have been screaming global slowdown since December. Stocks largely ignored this until last week and then had to play catch-up. I haven’t seen any sort of positive turn yet to make me think the coast is clear on stocks. I did a little bit of buying last week but in smaller size just as starter positions in some names I like longer-term. Not bullish:
- The broad stock market is also exhibiting a worrisome pattern after the 4-month Fed liquidity driven rally was wiped out in 1 week. This leaves a lot of trapped buyers that will want to sell on rallies. The momentum structure also looks the same. Because the breakout above resistance was rejected and we closed February is horrible fashion, this has created a bull trap (bottom pane in the chart below). Patterns like this can lead to much larger drops. On the S&P 500, if 2800 goes, I think we could trade as low as 2100 (about 30% below today’s current price). I’m not predicting a crash, or betting on one, I’m simply saying that the probability of one occurring is much higher than usual right now and it makes sense to be prepared. This is an ideal setup for put options. My tactical strategies have also been shutting off so I was happy to use the bounce this week to start closing those positions. The >4% rip on Monday is not bullish. You only see rips higher like that in bear markets. Believe it or not, it’s possible we still see new highs within a few weeks but unless it is driven by very broad participation, it will remain a selling opportunity. That’s exactly how the top played out in ’07. At this point, I wouldn’t bet on new highs though. If we have begun a bigger drop, these tend to play out in waves. You get really big bounces and then things can go quiet for 4 to 6 weeks and everyone thinks the worst is over, but then another wave of selling kicks in and drives us to new lows.
- The Fed did an emergency rate cut of 0.50% yesterday. This is not bullish for stocks. Rate cuts take about 18 months for the effect to feed through. This emergency cut is the official confirmation following the curve inversion that this is cycle is over. And the bond market is saying they still need to cut another 0.25% or 0.50% just to get back to a neutral stance. After the cut, yields on the long end FELL! The market is screaming that the Fed is being too complacent about the current risks. I understand that they cannot do anything to help stop the spread of COVID-19, but if they wait too long in a reactive fashion, it’s very likely we see continued liquidity issues in the markets. Overnight Repo auctions remain oversubscribed indicating that there is still stress and a lack of available liquidity in the banking system.
- The 10-year and 30-year Treasury yields continue to make new record lows, with the 10-year trading below 1.00% and the 30-year below 1.60%. The bond market is saying that something is seriously wrong. In short, I think we see the Fed Funds rate back at 0% pretty quickly and long yields will continue to converge down with the rest of the developed world (which range from -0.60% to 0.50%) over time. I’ve been meaning to do a longer post on the structural economic issues and will try to get to this soon.
- Treasury bonds are running out of juice as a hedge against risk as yields approach zero which means they will largely need to be replaced in portfolios. I’ve made it pretty clear that I think gold is in the process of doing that. This can also be balanced on the other end of the risk spectrum with income producing investments of higher risk – whether that is corporate bonds, real estate, dividend paying stocks, etc. If you are taking that route, the most important factor to consider is the durability of the cash flow, and I wouldn’t go this route unless you’re picking very specific names/holdings.
- The Stocks-to-Gold ratio made another lower low on last week’s drop and is holding right on this 2 year ledge of support. The long-term shift in trend continues. This is probably the most bullish environment for gold since 1971.
- I still think the biggest risks lie in the bond markets and that the corporate bond market is a ticking time bomb. In reminiscent fashion, as investors clamored for yield, Wall Street has obliged by providing them with no-covenant garbage loans (CLOs, bank loans, etc.). Funds have already started gating redemptions because these markets are so illiquid. If it spreads, I think the junk bond market gets wrecked just like in 2008. It can also pull down investment grade credit too as the bulk of these indexes are rated BBB, one notch above junk. If the economy does get hit from this COVID-19 shock, it could potentially trigger a wave of downgrades that floods the junk bond market. I flipped most of our investment grade bonds to short-term Treasuries today and we bought put options on HYG.
In short, given the already fragile economic state before the COVID-19 outbreak, I think the current environment poses the most risk since 2007/08. When managing investment portfolios, job #1 is risk management. Markets aren’t about making predictions, it’s assessing the probability of potential outcomes. When the probability of a bad outcome is high, especially relative to a low return potential, one needs to reduce exposure and get set in a position to eventually benefit from the opportunities that could be created by the dislocations. If things calm down, then great. The cost of being prepared is minimal. But the cost of not being prepared is overwhelmingly destructive.
Thanks for following.
-Nick