Models have a weird way of spitting all the right numbers at you if you put on a certain set of constraints, giving you a false illusion that “nothing can go wrong”. A model is after all just a clever mechanism to analyze a sample of data, data being the key here! The 1970s saw some of the highest inflation rates in history. Since 1980, after US inflation peaked at 12.5%, it has been steadily declining ever since. But the average investor in the market these days hasn’t been around long enough to know what inflation is, other than just reading. They always felt safe knowing that the “Fed put” was firmly in place, hence the buy-down mentality.
Investors and institutions have clung to this belief in an almost religious sense, a commandment carved in stone by a higher being. In the deflationary world of the last 40 years of data, so to speak, bonds and equities have been inversely correlated, providing perfect coverage in various economic cycles. The behavior of these two asset classes is behind the infamous 60-40 Risk Parity strategic risk allocation that is today the cornerstone of every financial advisor for institutions and individuals. The model suggested a delicate balance skewed 60% to stocks and 40% to bonds. This turned out to be the perfect hedge because if rates fell, the bonds would rise to compensate for the loss in equity, or vice versa. This strategy has worked wonderfully, until today. The pattern has firmly broken down this month as investors were crushed by both their buying of stocks and bonds. There is no diversification! So what has changed?
Based on the existing risk parity model, the current sell-off, the ultimate dollar margin call, is forcing asset managers around the world to sell everything indiscriminately, so they can raise cash, and quickly. In February 2018 when short volatility – Volmageddon – exploded wiping out the entire short volatility (VXN) structure to zero, it caused a ripple in that 60-40 portfolio, but what we are seeing today is essentially an 8-sigma event! Simply put, a mathematically impossible or 0.0001% probability of this extreme event occurring, as long as the dataset used is the only sample we have. Did we ever put data before the 1970s is anyone’s guess. Institutions piled into this trade by the shovel because they never anticipated it would collapse. There are many reasons why it is collapsing and why we may be entering a new paradigm shift in asset allocation. As the bubble of everything burst after 11 years of a long consecutive record bull run facilitated by the Fed printing endless quantities, the monster grew too big to feed, that ultimately the Coronavirus was the triggering pin a massive collapse in all asset classes.
It used to be that the 60-40 stock/bond relationship worked in a deflationary environment, but in this new world where the Fed and central banks around the world are printing money like there’s no tomorrow, we’ll enter at some point in a hyper inflationary world. In this environment, bonds and stocks will move together in the same direction, and the 60-40 pattern will no longer work. It remains to be seen, but 36 million retail accounts in the US were all advised to be in this old risk parity model because there was no “risk” given the performance of the past 11 years. . Wake-up call?
The S&P 500 has fallen 30% in less than a month, and we have officially wiped out the returns of the past three years during this time. Investors wonder if it’s low enough or if it can go even lower? In 2008, markets fell nearly 50% before bottoming out. It wasn’t the fall that shocked us, but the rate at which it fell. With the US now locking down, we can assume the second quarter will start to see the brunt of the extreme slowdown and possibly even print -5% GDP, according to Goldman Sachs. We are in recession now. A simple calculation on the back of the envelope can help put it into perspective. Earnings per share for the S&P 500 in 2019 were $135. Assuming earnings fall 20% – which is possible in a recession – the new earnings per share may be $108/share. Allowing a generous multiple of even 15x would put the S&P 500 at 1600 ~ another 30% drop. I’m not saying we fall a lot more. Suffice it to suggest that depending on the severity of the economic downturn and how long it will take to contain it, the weakness could last well into the second quarter. Once things stabilize, it will still take time to return to some form of normality, certainly not at the same accelerator as before the crisis.
According to the recent note from Nomura’s Charlie McElligott, the managers’ active exposure to US equities last printed lows in 2011 and 2014. This is what was sold aggressively. The sell-off was exacerbated by the sell-off of corporate bonds, investment grade bonds, Treasuries, gold and oil together, with a run in the dollar. The Fed bought about $307 billion in Treasury bills and mortgage-backed bonds this week compared to $162 billion purchased in March 2009 during the Lehman crisis. In one week, they injected more liquidity than during all of QE2. Today, the Fed alone will buy about $100 billion. The Fed’s balance sheet last week was $4.7 trillion, down from $3.7 trillion in September when they launched non-QE QE, but at least now it’s official. That’s a 50%+ increase in six months. Still, the index is struggling to make meaningful progress. One can imagine the amount of sales that absorbs all this liquidity.
Today is an important day because it is the week of the quadruple witch expiry, during which all index and stock options expire. March is the end of a quarter and therefore a lot of open interest will expire. This was a big factor and exacerbated volatility this week causing +-10% moves as dealers had to hedge long or short against market rallies and falls…negative gamma. Next week, volatility is expected to decrease as banks and dealers need less hedging. The month-end repo rebalancing will result in equity inflows versus bond outflows given the current size of this gap, in the $120-200 billion range, which will support equities short term.
The economic downturn and relentless hedging of short USD positions does not appear to be over as it will take time for deleveraging to stabilize. But there can be bad rally times, even in a bear market. As of today, now all technical and strategic indicators are super tight to the downside as we are in maximum bearish mode. Following the expiration of all that negative gamma, perhaps the sell has been exhausted in the short term?
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