Last week was one of the worst weeks in the history of the US stock market. Thursday’s plunge was the worst one-day loss other than the crash of 1987. Friday’s recovery was stunning as well but big rallies are typical of bear markets and that is, unfortunately, where we now find ourselves.
Obviously, the selling was about the coronavirus and our response to it. But there was much more going on in the shadows that exacerbated the selling across multiple asset classes. The deleveraging across markets was extreme and apparently forced.
There were rumors all week of so-called “risk parity” fund being the culprit, but it doesn’t matter what name you put on it. Leveraged funds were being forced by markets and their brokers to reduce risk. There were very large sell orders forced into a falling market. I don’t know who it was, but I bet we hear soon that a large hedge fund expired last week.
Risk parity funds own portfolios of multiple assets allocated by volatility. A simple example would be a 35/65 stock/bond portfolio, leveraged several times over to enhance the return. Theoretically, a portfolio such as this can deliver higher returns with lower volatility than more traditional, unleveraged balanced portfolios. The problem comes when the volatility of the assets in the portfolio change. A rise in stock market volatility would dictate the fund sell stocks into a falling market, which is exactly what happened last week (and sounds a lot like what happened in 1987 too, by the way).
We own bonds and gold for situations like this as they both tend to rise when the economy and stocks perform poorly. Last week they offered no refuge. The trouble actually started late Monday in the form of a large block trade in TIP (the ETF for Treasury Inflation-Protected Bonds); a 2.3 million share block, representing over $275 million traded in the last half hour. I noticed the trade the next morning but stocks rebounded Tuesday and while bonds were down, that made some sense in the context of a recovering stock market.
But the selling in bonds continued Wednesday and expanded to include other bond ETFs (TLT, LQD), even as stocks sold off as well. Bonds continued to fall Thursday morning as stocks crashed. Later that day bonds recovered some but failed again and followed stocks lower into the close. Longer-term bond ETFs continued to sell off on Friday with stocks recovering most of Thursday’s loss.
This sequence has all the hallmarks of a forced liquidation, a giant margin call. I don’t know that for sure – it could have just been a desire of some leveraged fund to reduce risk in an illiquid market – but it sure didn’t feel that way to me.
Sunday night the Federal Reserve cut the Fed funds rate by a full 1% and launched a new quantitative easing program of $700 billion. There were other measures announced as well, but the market reaction, at least so far tonight, is underwhelming. Stock futures are down limit and indications are that stocks will be down roughly 10% this morning. I would expect to hear more soon from Congress and the Trump administration on their next actions. Coordinated fiscal and monetary policy is what is called for right now and we might actually get it.
Last week, I wrote that we might see more severe interruptions to economic activity if the virus worsened. That is quite possibly the understatement of the century. I did not anticipate the dramatic measures now being taken to combat the spread of the virus. And I sure didn’t expect the panicked reaction of the public, now hoarding items such as food and toiletries that should continue to be readily available. Fortunately, the least affected areas of the country are the ones where they grow our food.
The question still remains as to how long this will last. As I said last week, if this lasts 4 to 6 weeks, we will have a large, short-term contraction of the economy. If it lasts longer and we continue to keep large parts of the economy shut down, the contraction will be deeper and the scars longer lasting. The biggest problem I see is that for many small businesses, this could be a fatal blow. Small businesses (less than 500 employees) are the backbone of the economy and employ almost half (47%) of Americans. Very few of them are prepared for a several-month shutdown. I’m not sure how to address that problem but it needs addressing immediately.
One potential clue on the length of the shutdown comes from Apple. They closed their China stores the first week of February and reopened them all by last Friday, almost exactly six weeks. China seems to have gotten the virus under control but it remains to be seen if the number of cases will start to rise again as they go back to work. South Korea seems to have followed a similar timeline. Apple announced over the weekend that they are closing all their stores outside of China. Let’s hope they are able to re-open as soon as they did in China.
That assumes we will be as successful in getting the virus under control, which may not happen. China’s methods of sequestering their citizens go well beyond anything that would be tolerated here in the US. South Korea doesn’t seem a very likely model either, since we are obviously not taking their test-everyone approach. Again, we are left to guess about the severity and length of the virus mitigation induced slowdown.
The extreme uncertainty makes it very difficult to value stocks in the short-term. Longer-term is easier if one assumes a return to the previous trend growth but that might be a rather large assumption. We don’t know the long-term impact of this virus; the flu is a coronavirus too and it comes back every year. The point is that stocks are really, really hard to value right now.
The market will eventually find a level from which it can ponder the future without swinging 4 or 5% on a daily basis. I don’t know from what level that will occur but as I said last week, counter-trend rallies are the norm in bear markets as news flow feeds optimism about a recovery. Speaker Pelosi has already said she’s working on another bill but the details matter and one can only hope that both sides can set politics aside for the good of the country. That is going to be hard in an election year, but I hope they can rise to the occasion.
As I said last week, we raised cash over the last two months so our typical moderate risk account holds over half its assets in bonds, cash, and gold. The hedge usually provided by bonds and gold did not function as well as we expected because of the dislocations discussed above. However, the Fed’s actions tonight should calm the bond markets and gold seems to be reacting positively too, at least in Asian trading.
I’ve said from the beginning that we would follow our process and that is still the case. But we also need to be realistic. We now have two of the three indicators we normally expect to call recession and the third one is derived from economic data that is going to fall and fall hard. I don’t like predicting the predictors but it seems pretty safe to assume a contraction at this point even if we don’t know the length and depth of it. If we are lucky it might only be for a quarter, but there is little doubt that it will come. I suppose we should hold out the hope of a therapy or cure from an existing drug – and we know they are testing several existing anti-viral drugs right now – but it would have to come very soon to make a difference.
So, what do we do with our portfolios? We will be considering the following when making any changes to the portfolios:
- Gold, even with the sell-off last week, is still outperforming the S&P 500 over the last month by a wide margin, -3.44% vs -20.1%
- Bonds are outperforming by an even wider margin. The 3-7 year Treasury index, which is our default bond holding, is up 3.1% over the last month. Even TIP, ground zero for the bond market misbehavior, is only down 3.7% over the last month. Corporate and high yield bonds have also performed better than stocks, although both are down.
- Commodities, generally, didn’t perform too poorly. The indexes are weighted toward crude oil and so got killed by the Saudi/Russia feud, but copper was down just 5.7%. Natural gas was actually higher over the last month. Others were just down slightly including corn, coffee, grains, and nickel. With the Fed’s new actions commodities may continue to outperform. Especially if the Saudis back off and oil prices can rise a bit.
- Growth continues to outperform value and the NASDAQ continues to outperform the S&P 500. Will growth companies be less affected by a downturn? Tech companies?
- Emerging markets have outperformed the S&P 500 slightly over the last month but that short-term trend accelerated last week.
- China has outperformed strongly since the beginning of February (that’s part of the reason EM stocks have outperformed; China is the biggest part of the index). Has the Chinese central bank – or some other state entity – been buying stocks? That seems likely but it could just be that China is further along in this process than we are.
- Asia ex-Japan has also outperformed strongly due to its heavy China weighting.
- Japan was outperforming until Friday and is trading higher tonight. That trend may reassert itself.
We monitor both short and long-term momentum across markets. Short-term momentum can shift quickly and we don’t generally chase short-term trends. Longer-term trends are harder to break and when they do, we pay attention. Last week broke some long-term trends in US stocks. The swiftness of the move was driven by the deleveraging I discussed at the open of this update, but I suspect we would have ended up here anyway.
Sitting here in the wee hours of Monday morning, things are looking pretty bleak. Large parts of the US economy are shutting down to try and weather the viral storm. The stock market is shaky and the bond market is about to go on Fed support. Now is the time to remember that we will get past this no matter how painful. At some point soon, likely weeks or months, the US economy will be back on its feet. How our lawmakers perform in the next few days may determine to what degree. If we allow large numbers of small businesses to fail during this shutdown, there will be no quick snapback. Let’s hope the President and Speaker understand that and find a way to provide a safety net to the small companies that really make America great.
