Monday, March 16, 2020

Eight Reasons Why It Might Not Yet be Time to Buy

Under normal circumstances, a selloff of the scale and breathless rapidity as we’ve seen in early 2020 would mark a prime opportunity for bargain-buying of financial assets, notably stocks. The Morningstar fair-value ratio for the equities market as a whole is down to 0.83, off its recent highs above 1.06 – ostensibly describing a market even more oversold than it had been overbought a month ago. The Fed and other central banks around the world have promised liquidity infusions, the coronavirus seems to be slowing in Asia, the White House has signaled consumer-oriented tax relief, and the CBOE Volatility Index, or VIX, has literally never closed at this high a value in the history of its existence, a fact which in past selloffs has presaged a more-or-less immediate rally. Under normal circumstances, a decision to take fresh long positions in equities would stand as near to a can’t-miss play as amateur investing may reasonably allow.

But of course these are not normal circumstances.

So what exactly could derail the conventional metric for buying as low as this, and selling higher later? Several things, as it happens—perhaps as many as eight of them—the combined gravity of which should chasten even the boldest bulls to season their time-tested buyers’ instincts with more than a pinch of circumspection.

1. Central Bank Interest Rates Around the World Are Much Too Low to Effect Much Direct Intervention by Lowering Them More. Monetary stabilization isn’t confined to manipulating target rates during market selloffs, of course—but that’s unusually good news this time around, because answering this selloff with public announcements of further rate-cuts isn’t just impractical; it’s more or less impossible. Central Bank target rates around the world are, in many cases, already as close to zero as they can get—in some cases as close to zero as they’ve ever been in that particular Bank’s history—and even with liquidity infusions as a backup plan that’s a big problem, because John Q Public looks to the announcement of rate-cuts as his signal with which to gauge the vigor of more abstruse monetary interventions behind the scenes.

With such a “signaling effect” taken off the table, many are likely to opt out of the macroeconomics lecture necessary to understand and take solace from secondary policy tools. Put simply, perception is everything when it comes to power of the Fed, and right now the perception in many circles is that the quiver is as close to empty as it has ever been.

Even worse, the news stories have become so ghastly, both generally and in terms of their economic implications, that the typical inverse relationship between central bank rates and the stock market has completely broken down: Instead of responding to rate reductions with a sigh of relief, markets have interpreted them as a more dire sign of trouble ahead.

2. There is Also a Large and Growing Bubble in the Bond Market. Ordinarily a central bank policy of low interest rates should be good news for stocks, yes, but it also should be bad news for bonds—at least long term. Stock investors favor low interest rates because they lubricate business investment, while bond investors worry that any subsequent rate increases will undermine the resale value of their low-yield bonds. (This is where the old saw about bond prices moving opposite of yields, comes from.)

The trouble for policymakers starts when low central-bank rates fail to sustain a bull market in equities, in response to which the public starts gobbling up bonds in an effort to protect themselves. When this happens—a so-called “flight to quality”—the resulting overvaluation of bonds can lead to an eventual selloff there as well. This in turn causes higher borrowing costs for corporate expansion projects, and can lead to increased default risk at the less credit-sturdy end of the market. And none of that bodes well for a fragile rally that might manifest over the next few trading sessions. And that scenario should genuinely worry amateur investors, precisely because....

3. This Exact Pattern Has Broken An Entire Stock Market Once Before. Permanently. For more than a generation in the 1950s, 60s, 70s and 80s, a retail investor who’d put all of his or her money in Japan’s Nikkei would have experienced the sort of halcyon returns that stock markets are only supposed to afford during the frothiest of short-term, bull-market bubbles.

And then? Then it all, just ... broke.

A major selloff in New York, coupled with the strong-dollar policy of the second term of the Reagan Administration, together plunged the Japanese export sector into a deep recession. The Bank of Japan responded by cutting rates as much as they could, just like clockwork, but the resulting bubble in the corporate Japanese bond market suppressed business investment and stole the national mojo for risk-on investing of any kind. Today the Nikkei is lower than it was thirty years ago.

An investor who’d envisioned the Nikkei selloff as an excuse to buy low on Japanese stocks would still be in the red, thirty, years, later. We in the west love to say that, over the very long term, equities average ten percent returns—but we say this because we haven’t the faintest idea what “the very long term” is. In truth the Dow and S&P have averaged ten-percent returns only since the end of the Second World War, or about as long as we’ve trusted that a company built around the B-29 wasn’t going to kill us with passenger planes that had a nasty habit of dropping unbidden from the sky.

None of which is even to touch on the potential implications of the coronavirus itself—which, even if new infections dropped to zero tomorrow, would still exact a far steeper price on the world economy than most people have yet recognized.

4. Global Supply-Chain Disruptions Will Lag the Arc of the Virus Story in the Media. One of the axioms you may remember from college economics is that “unemployment is a lagging indicator”: Firms experiencing an unexpected shock to their customer demand will respond in almost any other way before trifling with their employee numbers. A firm whose demand decreases unexpectedly will tap into its available contingency plans—either to build its inventory, reduce overtime eligibility, encourage the taking of paid leave, or trim its budget for risky experiments—all before laying the first worker off.

This makes sense: Turnover is one of the biggest hidden cash drains from which a modern company may suffer, and a hair-trigger to furlough or dismiss under-utilized employees can generate negative word-of-mouth far quicker and with far greater impact than some employers have yet realized. H/R processing costs, maintenance of workflow continuity, and the fostering of a healthy office culture all present their own challenges to the bottom line whenever a firm’s head-count goes up or down.

But just as a well-versed metal fabricator in Shenzhen wouldn’t want to hire or fire anyone until it was absolutely necessary, neither would he or she default on deliveries until even the payroll-panic-button had first been pressed. Except in extreme cases, basic contingency planning should afford an interval of comparatively stately dissonance for each international contributor along the chain—but, just as with conventional shocks, these contingencies all have finite efficacy. And when they are exhausted there can be no uncertainty about the depth and scope of the subsequent disruption to world trade. All of which suggests that many of the effects of the present crisis—the real, bottom-line effects—could be weeks and possibly months away.

5. The Potential Recession Hasn’t Even Manifested Yet. If anything should chasten the would-be bargain buyers eyeing the stock market, it is that every last dollar of selling we’ve seen so far has been speculative. Yes, the coronavirus story has exacted noticeable impacts anecdotally, but there have as yet been few rearward-looking macroeconomic statistics to validate the fear that grips the Street.

Selloffs in equities markets have three causal triggers: They re-balance share prices after bubbles (check), they manifest widespread alarm in cases of “black swan” events like viral outbreaks (check), and they rationalize share prices to match decreased profits during real economic downturns. What should make this fact so scary for bulls is that, this time around, the third causal trigger may still be in the offing. With a Morningstar Fair Value Ratio this low, it may be argued pretty convincingly that stocks are under-priced right now and oversold—but the other way for an under-priced asset to self-correct is for its underlying value to decrease to match the lower price.

If the major economies of the world really are about to manifest some serious real-goods-consequences of the present chaos, the apparent bargain-pricing of stocks could easily evaporate without a single penny’s worth of capital appreciation to show for it. And consequences for real goods and services are a phenomenon with which the world’s investors have precious little recent experience:

6. The Biggest of History’s Most Recent Corrections Have Largely Spared the “Real” Side of the World Economy. If asked to name the biggest market corrections in memory, a person working backward from today would probably start with the financial meltdown of 2008, the September 11th attacks, and the dot com bubble. These three corrections have a major commonality that is rarely considered—namely that all three of them were largely confined to the financial side of global commerce. Neither demand for, nor the supply of real goods and services were proportionately disrupted.

It seems increasingly unlikely that the present selloff will preserve this pattern. Travel- and hospitality-related industries already find themselves in deep distress—some of it literally mandated—and with the aforementioned supply chain difficulties contributing their own negative influence in the spheres of consumer durables and information technology, the probability of a systemic and worldwide economic slowdown becomes impossible to dismiss, particularly as an argument against bargain-buying equities at this time.

7. The Price War in Hydrocarbons is Only Just Getting Started. One of the strangest facets of life as a twenty-first-century investor is that the fortunes of one’s portfolio tend to vary directly with crude prices, rather than inversely as a person might have learned to expect. Lower oil prices should be good news for any number of industrial and even post-industrial stocks, from General Motors to Federal Express, but whatever windfalls might be associated with cheap energy have in recent years been roundly overtaken by the negative impacts on large and highly regionalized segments of the American workforce. It is in the context of this new causal relationship that the recent collapse of a historic member-non-member agreement between OPEC and other major oil-producing countries (notably Russia) has weighed so adversely on US equity prices.

Indeed it has been suggested that Vladimir Putin’s real target in the present oil spat isn’t Saudi Arabia but rather the froth-dependent US oil shale industry. If this is indeed the case, and if the fate of those producers continues to wield a pro-cyclical influence on the fortunes of broader US indices, it seems unlikely that Mr. Putin will stop pumping excess oil until the western consequences have extended far beyond those we’ve seen.

8. No One Really Knows How Bad the Coronavirus Outbreak Will Get. Superficially the virus story seems to be finding its plateau, if not yet its dénouement. Nobody on the planet should take the recent news out of China in any spirit other than relief, for one thing. But neither would it be wise to apply the Chinese trajectory to forecasts of the western timeline for the problem. The Chinese had several major advantages in combating this outbreak, from their ability to enforce draconian solutions top-down, to their far more unified public response, to (let’s face it) their vastly better-prepared healthcare capacities and infrastructure.

Western powers in general, and the US in particular, are far less organized in their response, far less empowered to improve that organization, far less cohesive—especially regarding how seriously the issue is being taken—and in general just embarrassingly less prepared. None of which augurs well for the short- and intermediate term prospects for containment. Indeed a congressional staff physician was recently quoted predicting that one third of the US population will contract the virus. Let me just repeat that: A physician in the employ of the United States House of Representatives has predicted, out loud and on the record, that one third of the entire US population will contract the coronavirus.

Should such a prediction come true—come anywhere close to true, come anywhere close to coming anywhere close to coming true—the impact on US equities could make what we’ve seen so far look like the good old days. The upside of which is that, if things really were to unfold this way, decreased stock prices would hardly matter.

9. Strategies. Let’s be clear: A lengthy column crafted to discourage bargain-hunting would amount to little short of malpractice if at least a few inches weren’t here devoted to the equally unpalatable conditions now facing bears. Neither the Fed nor the Treasury is taking the crisis lying down, and new virus cases in Asia—as previously mentioned—would seem already to have leveled. Selloffs driven by bad news tend to melt away very quickly when the flow of bad news isn’t continually refreshed, which would suggest that the fate of short positions moving forward will be unusually dependent on future events. And while a certain amount of luck is always a key ingredient to profitable investing, it should go without saying that a sole reliance on luck is a recipe for red ink.

So it’s a bad moment to be a bull, and a bad moment to be a bear, and a bad moment for flight-to-quality (due to the overpriced bond market). The obvious question to ask is, okay, how should small-scale amateur investment portfolios be balanced in the near term?

Cash is the obvious answer to this obvious question, and really it’s not hard to imagine scenarios in which a 100% cash portfolio “pays” a decent return over the next year. Deflation last occurred in the major western economies so long ago that few are still alive to remember it, but with real interest rates this close to zero deflation becomes once again a viable possibility. (At the very least, rates this low should paradoxically discourage the taking on of any new consumer debt, pending some clearer signals regarding the intermediate-term fate of the US dollar.)

But what of those among us whose personal standards of living are dependent on returns from our portfolios? Surely there must be some solution available other than to eat the nest-egg while awaiting better choices? Surely there must be one non-cash play, available and attractive right now? Indeed there is—though it should be emphasized that the strategy described here is not for the faint of heart, because it involves purchasing options.

Put as simply as possible, an “option” is a contract that permits a person to buy or sell something at a later date for a prearranged price. If the price of the asset deviates from the one agreed upon, the owner of the option gets to keep the difference.

Say for example that an investor had purchased options to sell shares of an ETF tracking the S&P 500 at 3,200 on the day before the start of our present spasm of economic turmoil. Were she to exercise that option today, the fact that the S&P is at 2,400 would entitle her to a dramatic profit, since the shares necessary to cover her sale would cost so much less to buy.

This much is always true and always potentially attractive, but the critical feature of the example above, is hindsight: Our hypothetical investor didn’t know that Tom Hanks and his wife would get sick on a movie set in Australia, or that restaurants and bars would be closed in entire cities, when she bought her put—and if she’d been wrong about the intervening direction of things, she could have lost her entire investment.

So why on earth would a time of increased market chaos like this recommend itself as an unusually good time to be playing assets for which a wrong move could come to a loss of the entire purchase price? Because with one minor tweak our hypothetical investor wouldn’t actually need to correctly call a big move up or down in advance. She’d only need to correctly call a big move.

Let’s make it crazy-simple, just to show how this might work. Suppose a put option on an S&P index ETF is available for $100, and suppose it pays $1 for every point that the S&P moves lower between now and April 30.

Since the option itself cost $100 to buy, the underlying index would have to move down by the first 100 points just to break even--below which every subsequent point of downward movement is $1 of net return for our investor, with an unlimited profit potential from there. But if the S&P goes up instead, our option-holder is out of the money. She doesn't exercise the option, since that would leave her even deeper in the red, and thus she loses her entire $100 up-front cost. Unless, that is, she simultaneously purchases a buy option (called a “call”), for another $100, at the same time:

Obviously one of these two bets is guaranteed to be wrong, but here’s the thing: As long as the S&P moves in either direction by 201 points or more, our investor can concede the incorrectly placed bet and still come out ahead.

This is referred to as a straddle: A bet that the market will move significantly enough to cover the cost of the two options—without knowing which direction.

The attraction of such a play at this particular instant in time simply cannot be overstated--both for its own reasons, and for the unattractive alternatives: Long positions would be an unbearably high-risk proposition for much of the remainder of 2020 at the very least, while a record-high VIX dangles the potential that new short positions might appear not so much foolish as suicidal. But what seems abundantly clear at this moment, more so than perhaps any previous time in the history of amateur investing, is that exactly one of these two plays will seem supremely foolhardy in retrospect—and that is exactly what a straddle option would require, in order to pay off. Either the conventional dynamics for stock market recovery would need to reassert themselves, or else the reasons that they fail to do so would have become impossible for the market to endure by treading water at today’s levels.

And either scenario should pay a straddle-holder, with the added benefit of not needing to hang on every new development in the increasingly harrowing daily news.

Dave O'Gorman
Phnom Penh, Cambodia
17 March, 2020

1 comment:

Anonymous said...

#4 was particularly interesting to me tonight.