The current financial crisis is the fifth one I have experienced. It is not very different than the other four. As usual, markets went from being completely complacent to completely panicked in a matter of days.
In January, I wrote a piece in this forum about “market avalanches”, and how sunny weather and inviting slopes in the winter can bury you in minutes if you are not prepared. Unfortunately, this time, just as the last four times, many investors chose to try to race the avalanches unhedged and unprepared even though the signs were evident that things were getting precarious. Some banked on diversification to work out. While others banked on liquidity and gold to help them stay the course. Many of these cute “free options” did not quite work out very well. I also referenced in that piece Bob Shiller’s book that uses the metaphor of pandemics in markets. Little did I know that the analogy, while so useful, would be so tragic for life, markets and economies around the world. The pandemic of fear, once started, is impossible to close off by cancelling flights, quarantining people and restricting travel.
I have been working 20+ hours a day at my desk for the last three weeks, and today, in what seems like the peak of the market panic, I have a few moments to raise my head and summarize what I am seeing, and what my experience indicates we can expect for the days to come. This too will pass, but it won’t be immediate. Here are the reasons why.
The most important thing that I am seeing is the total evaporation of liquidity in almost all markets. The Fed and other central banks think that by performing repo operations they can provide liquidity to panicked market participants and the economy. That “un-fact”, unfortunately, is a pipedream that only a nightmare like this week’s markets can set straight. Their liquidity is not going to the market – it is being hoarded like Costco toilet paper. The Fed just did a repo operation to buy Treasuries ($500 billion!) which boggles the mind to an already short of Treasuries market. They need to provide bonds to pensions and other hedgers, not indirectly suck it out of the system. Perhaps a massive fiscal issuance of long bonds is not too far behind, we can only hope.
What is notable (as per dealer reports and my own foggy tired eyes) is that the current liquidity in the two deepest financial futures markets, the E-mini S&P contract, and the Treasury futures markets, is only one 20th (5%) of average liquidity of the last five years. I have seen liquidity cycles for three decades, and this is the worst ever. The bots are out of the market, and its mano a mano, just like the old days. Ponder that for a moment. If you are a believer in systematic delta hedging, risk-parity, volatility selling strategies, the simple truth is that if you have any size to move you won’t be able to in such illiquid markets. Finance theory meets fear, and so far fear is winning.
I expressed my concern to our clients a couple of days ago that this fear is that we fall into a liquidity black hole that even the Central Banks cannot tame. As I wrote in a paper in the Financial Analysts Journal with Larry Harris two years ago before the XIV debacle of February 2018 (aka VelocityShares Daily Inverse VIX Short-Term exchange-traded note), the volatility selling ecosystem could create a delta hedging response which is similar to what we just saw. Not surprisingly, there was a lot of criticism of the paper from self-interested parties, but hopefully regulators who did not think it was a systemic issue then now see that it is a serious problem. If the ecosystem of unlicensed selling of financial market insurance is not curbed or controlled, this little bear market could mushroom into something really serious.
Note that given the proximity of the zero bound, and after a great run, sovereign bonds and duration overlays are not performing any more as hedges. This is not surprising since yields are almost at zero worldwide. After a dizzying rally of 30-50 basis points in the Treasury markets overnight for a few days in a row, it seems that investors are not willing to buy more Treasury bonds, since to get the same price performance from here on, the whole yield curve has to go deeply negative. In fact I am seeing much outright selling of sovereign bonds to generate precautionary liquidity. German Bunds are already in deeply negative territory, and they have quit responding to falling equities. The ECB’s actions tonight will be critical in setting the tone for global equity markets. I don’t expect much other than what they have already been doing, i.e. cutting rates and buying more bonds that the market wants. Unfortunately doing more of what does not work is becoming a tradition. The possible silver lining is a German fiscal plan that could supply the world with a much needed supply of bonds. The ECB should also stop buying up European bonds, since the liquidity only flows into financial assets, creating air pockets when it leaves.
Also pay attention to the slow leakage in corporate credit spreads that could accelerate. As the equity markets fall and volatility indicators hit all-time highs, spreads are widening out. This is ominous, because low interest rates have allowed corporations to buy their stock back for the last half decade at a record pace. As spreads widen, the “arbitrage” between total equity yield and corporate borrowing rates collapses, leading to fewer buybacks. And indeed we are not seeing the early morning buyback bid that we saw for the last few years. Some Central Bankers have proposed buying corporate bonds. Big mistake, since it will just spread the disease of zombie capitalism into the hands of the tax-payer.
Long dated implied volatilities in most options markets are beginning to tick up. This may create a feedback loop into risk asset prices. Signs of capitulation are everywhere. Russell 2000 vs. S&P has restarted its major trend of weakening. This is usually a precursor to a sharp meltdown as the small, weak hands have to liquidate their companies. Even after a 10% percent underperformance, this “value-trap” could still claim more victims.
So having seen these a few times what should one do? First, try to do nothing. Just observe, if you can bear to peek at your 401K balance. If like me, your kids are going to be out of school for two weeks maybe spend some quality time with them and even learn how to play Minecraft – the virtual game via which they uncannily prepared for the “social distancing” movement. Second, if you still have the urge to to do something, try to maintain liquidity. Third, look for opportunities where the baby is being thrown out with the bath-water, e.g. ETF selling that sells stock baskets and depresses the good and bad securities alike. In short, this is time for thinking actively, not just throwing money at the market and hope it multiplies, which unfortunately many of us have become too used to.