Amid the intense volatility, records have been broken in the stock market over the past couple of weeks.
As of Friday’s close, the stock market (as measured by the S&P 500) has fallen -32% from the all time high reached just a month earlier on February 19. The current descent is by far the most rapid plunge into bear market territory from an all-time high. To put the rate of descent into context, it took the S&P 274 days to enter a bear market during the financial crisis.
On Monday March 16, the S&P 500 dropped almost 12%, the worst one-day fall since the 1987 stock market crash.
The speed of this decline is due of course to the spread of covid-19. What we have witnessed is the rapid and simultaneous shutdown of huge parts of the global economy. Something markets have never faced before and something they’re struggling to discount.
The VIX last week hit a 12-year high of 85.47. This reading has only been eclipsed twice. It reached 89.53 the week Lehman collapsed in 2008, and it hit 172.79 in October 1987 ( but the index was calculated differently then, so it’s not directly comparable). It shows the extent of fear currently present in the stock market.
Up until two weeks ago, I only recall seeing one limit down day in the S&P futures. Since then we’ve seen 6(?) limit down days and 3(?) limit up days. These numbers are my best guesses…the past two weeks in the stock market feels more like a couple of years!
Lets take a look at some charts, to better assess the carnage:
We need to zoom out to the weekly chart of the S&P 500 to fully appreciate the damage wrought in the stock market over the past three weeks.
Last week the S&P fell -15% and closed below the low of December 2018. It’s now only ~8% above the level it was at when President Trump won the 2016 election (red line in the above chart).
The Nasdaq has fared rather better, falling -12.5% an importantly, is holding well above the 2018 low. It’s currently at a minor support level (the June 3, 2019 low).
A huge amount of technical damage has been wrought on the Russell 2000 (IWM). It fell 15% last week and currently sits just above its 2016 low.
The Dow Transportation Average (IYT) has fared the worst of the major indices. This is hardly surprising given the plunges we have seen in airline sotkcs, for example. It has now fallen approx -42% from its all time high.
IWM and IYT have been lagging both the major stock market indices for quite some time. IWM and IYT both peaked in 2019 – neither was able to record at new high in 2020 and both have been leading the way lower in this selloff.
The VIX has been recording movements of 20 points a day over the past couple of weeks. Pretty incredible when you consider that the VIX barely traded above 20 points over the past few years.
The VIX closed lower on Friday despite a weaker stock market, and now looks to be putting in a top. THis may may mean stocks will look to find a short-term bottom soon.
The failure of “buy and hold”
People invest in “buy and hold” (“buy and hope”) portfolios that are diversified, with the aim of exploiting the theory that investing in different asset classes with a low correlation to one another will smooth out the returns in a portfolio.
The big problem with this theory is that whenever a crisis hits, the different asset classes all start to correlate with each other very closely. When fear strikes the markets, all asset classes tend to fall at the same time. We’ve seen this movie before!
In other words, diversification works fine when you don’t really need it (when markets are relaxed and trending up) but fails you terribly when you need it most (when the sh*t is hitting the fan).
Nowhere to hide
Let’s look at investment grade bonds. These are are usually the “safe” part of an investor’s portfolio. Imagine if your “safe” investments performed like this:
Or maybe you don’t have to imagine? Above is a chart, LQD, the largest ETF tracking investment grade bonds. In nominal price terms it has fallen from an all time high back to 2011 levels in TWO WEEKS!
The corporate bond market does not appear to be functioning well. An ‘A’ rated company (EOG Resources) couldn’t issue debt on Friday. A deal was announced and then “postponed”. This sends a very poor sign.
Gold, another traditional safe haven, has seen a sharp selloff:
While silver is back at 11-year lows:
There have been very few places to hide in this selloff, which is what we always see during every crisis. This is why I am such a strong advocate of people learning how to trade both sides of the markets. Or at the very least, learn about active risk management strategies like hedging.
The timing of this selloff is concerning. The average age of the Baby Boomer cohort was 65 in 2019. They are retiring in their droves, and they need this money for retirement. They cannot “buy the dip”. In fact, they are more likely to be net sellers of equities and other investments as they fund their retirement. Either way, a large chunk of “dip buyers” from 2003 and 2009 won’t be buying the dip this time around.
Raoul Pal over at RealVision has done an excellent job of explaining the looming pension crisis. I thoroughly recommend checking out their top-notch macro research on this, and other topics.
So…make money in this stock market? How?
Yes, it is possible to trade profitably in any market environment when you trade options. I was very well hedged with index put options throughout February and heading into this selloff. They performed beautifully and I had a great month in February. March has been a little tougher, but my account is still positive for the month.
Even among the carnage, there have been stocks that have been good performers. The “stay at home” and “work from home” stocks in particular have done well.
I’ve had profitable trades this month in Amazon (home delivery), Citrix Systems (market leader in remote access), Netflix (makes quarantine bearable) and Teladoc (covid-19 vaccine?).
Zoom communications (ZM) has also done brilliantly. ZM has danced to the beat of its own June throughout this selloff, but unfortunately I didn’t get on board this one.
And have a look at Papa John’s Pizza (PZZA)…up +78% from Wednesday’s low! I didn’t trade that one either.
One of my awesome LinkedIn followers pointed out that this weekend that I have been sounding quite bullish over the past week or so. And I admit I have, so I think some clarification is on order.
I’m structurally bearish. I think there is a major risk of another credit default cycle in the not-too-distant future. If this eventuates, I see the market making lower lows in the coming months. Possibly significantly lower, time will tell.
But I am a short-term options trader. As such, I have no intention of sitting on piles of cash or gold for the next six or twelve months, quietly waiting for signs of the ultimate bottom. If you are a long-term, long-only investor, this may be a strategy for you? But it’s not my style of trading.
And after the historical fall we’ve seen in equities, I am expecting a Newtonian snap-back rally at some point soon. So I am inclined go be on the lookout for a short-term bottom in the stock market.
I also need to point out that as an options trader, I trade with very defined risk. Most of the strategies I’m employing at the moment don’t even require the market to rally for me to be profitable. I just need the market to not fall much further. And if I’m wrong, I will have no qualms about getting out with a small loss. No questions asked.
How could I be bullish when everything looks so awful?
Market bottoms, whether short-term or long-term, are never formed when everybody is feeling good.
Market bottoms always occur when everything feels awful.
There is a popular sentiment at the moment that “the market won’t bottom until a cure for the virus is discovered”. Indeed, if history is any guide, markets will likely have already rallied significantly by then.
So if we are looking for a market bottom, we want to see fear, despair and disbelief that stocks can rally.
And that is exactly what we are seeing:
Hardly anyone believes stocks can rally right now, which is what we want if we’re “bottom fishing”.
The put/call ratio indicates a market that is extremely short. I don’t recall ever seeing readings as high as what we saw last week. Snap-back rallies can occur out of the blue when the market is this short.
As noted above, we are also seeing tentative signs of the VIX forming a top.
The S&P 500 is also trading a very long way below its mean. We should expect some reversion to the mean at some point.
In addition to the technicals, I should mention the range of both monetary and fiscal stimulus plans announced this week.
Congress is discussing a $2 trillion fiscal package this weekend. The Fed balance sheet has moved up to $4.668 trillion, a new high. Last week it increased $356 billion, the largest weekly increase ever (previous record was $292 billion in Sept 2008). Germany, too, has announced a fiscal package worth 10% of GDP. The kind of globally coordinated fiscal plus monetary action should help to reinstall some confidence in markets.
Now is not the time to short the market in my opinion. Puts are extremely expensive and the S&P is already a long way below its mean. I don’t like the risk/reward of getting short here and would prefer go do so after a rally. I’m long, but my positioning is very light (currently ~90% cash, ~10% long).
Making sense of it all
My view? In the short term, I am looking for a bottom in the stock market. Long-term however, my level of concern is high. For the reasons outlined above, I am an the lookout for a short-term bottom in the stock market.
I expect we’ll need to see a gap down on the open on Monday and sell off Monday morning, to put in a “capitulation low”. My positioning is light and most of my positions won’t actually require the market to rally much for me to be profitable. I’ll just need for it to not fall too much more.
If I’m wrong, I will know pretty quickly and I’ll have no qualms about cutting positions that aren’t working. Indeed, if the stock market can’t find some footing soon, things could get much uglier quickly!
What the markets are now trying to decide is whether the covid-19 outbreak is causing a short, sharp, economic heart-attack that markets and economies can rebound from. Or whether this is the start of a major economic down cycle. I think we are more likely facing the latter scenario. I think the news on the coronavirus will end up being better than the consensus expects.
With global travel at a virtual standstill, proper quarantines and social isolation, I think there is a good chance this virus will kill far fewer people than many fear. There is also the potential for development of a vaccine, which could drastically reduce infection and mortality. However, I think the economic news will end up being worse than the consensus expects.
A global recession seems unavoidable at this point. In fact, I expect we are already in one. And in a world with $250 trillion in debt and multiples of that in derivatives, a credit default cycle seems likely, if not yet inevitable. This leads me to the conclusion that lower lows for the stock market are the higher probability over the coming months. Potentially much lower, if we do enter a credit default cycle.
Please bear in mind that my perspective is one of a short-term trader, and nothing I write in my articles constitutes investment advice. Good trading!
PS – here’s a link to a LinkedIn post containing some reasons for hope on the virus front.