The world has changed rapidly over the past four weeks. It almost seems that January was part of a bygone era, making now an opportune moment to review the past four weeks and assess the current environment.
Significant challenges to the economy remain as the impact of COVID-19 evolves. In the markets, no news can be worse than bad news, and this week we will begin to get some insights into how the economy is actually responding. The expectation is for significant increases in jobless claims. Hopefully, the bad news is already priced into the market, but that remains to be seen.
Volatility shifted into high gear last week with large daily moves in both directions, although markets ended the week significantly lower. The S&P 500 is now down nearly 32% since February 19th.
This COVID-19 led market downturn evolved in stages:
- The first stage was a shock to the global supply chain as factories in China closed to deal with the virus when it began to spread rapidly.
- Markets responded by selling off, but the thought at the time was that this would be a temporary shock with a “V” shaped recovery as things returned to normal.
- The situation quickly shifted from supply shock to demand destruction as the virus was discovered in South Korea, Iran and Italy and began to spread quickly.
- Economic activity ground to a halt in much of the world as quarantines were implemented to reduce spread of the virus. Fear and uncertainty increased, and the panicked selling started to build during this stage.
Things then went from bad to worse when an unrelated event came out of left field and shocked the market. Saudi Arabia thought it would be a good time to strike back at Russia’s refusal to curtail oil production. The Saudis announced they would increase oil production by 300,000 barrels per day, which drove oil prices down from $37 per barrel to as low as $20.
The Saudis’ stated intention was to force the Russians back to the negotiating table, but the move has forced the US shale oil industry to begin direct talks with the Saudis, OPEC and Russia in an attempt to control worldwide production.
US shale producers carry heavy debt loads on their balance sheets, and need oil prices closer to $40 per barrel to stay solvent. Suddenly, potential bankruptcy of small and mid-sized US energy companies became an urgent concern rather than a remote possibility.
The oil shock and bankruptcy fear rang through the credit markets. Junk bond prices fell sharply, and volatility of prices on investment grade corporate bonds and even US Treasury bonds jumped. The Federal Reserve was forced into measures to backstop liquidity providers to keep the markets from seizing.
The oil shock and credit market stress seemed to have been the last straw on the equity markets, which led to last week’s surge in volatility. In addition to the panicked selling, there was also a substantial amount of forced selling that further roiled emotions.
Prior to the crisis, many of the large hedge funds and asset managers were “levered long” to the stock market. This simply means that they owned stocks and had borrowed additional money to increase their ownership. As prices fell, firms were forced to sell positions – further feeding into the selloff.
A simple example of this effect is taking a margin loan from the broker or custodian (like Schwab) and using the value of your securities as collateral. When prices fall far enough, the custodian issues a “margin call”. You either have to deposit cash or sell positions to cover and increase the value of your collateral.
In the case of hedge funds, the leverage was magnified by the use of derivative contracts like options and futures.
In addition to the forced selling related to deleveraging, there was also forced selling related to passive investment strategies and engineered rules-based strategies. The most common passive strategies are index funds like the S&P 500 Index Fund, for example. The rules-based strategies are sophisticated programmed algorithms that react to the market environment. Value at Risk and Risk Parity are examples of rules-based strategies. Since passive strategies do not allocate to cash, they are forced to sell shares to meet redemption requests. Many rules-based strategies are programmed to sell when market volatility changes quickly.
On top of the emotional selling and forced selling, Friday was also the expiration date for 3-month options and futures contracts. A perfect storm feeding into the panic.
What Can We Expect Next?
Now that the pressure of expiring option and futures contracts are behind us, and the forced selling to cover leverage, there is hope that markets will begin to calm to some degree this week.
However, fear of the unknown remains the primary sentiment in the market. The next stage of this market will focus on liquidity concerns and the Federal Reserve’s response as well as jobless claims and Washington’s reactions to the economic damage.
We continue to adjust our equity holdings as we can now find more quality companies with attractive valuations. We also are working diligently to monitor and assess the credit quality of clients’ fixed income holdings. This is the defensive side of the portfolio that has helped to offset some of the equity volatility. We want to maintain high quality bond positions as recessionary pressures build.
The real attraction to bonds is not simply the yield, but rather the lower risk profile and ability to mitigate overall portfolio volatility. The fixed income portion of the portfolio is there to help fund needs over the next 5+ years, giving time to let the stock portion of the portfolio recover.
Stocks will recover, and you do not want to miss the first leg up. It is frequently the most intense part of the rally. Read more about the speed of recovery here.