Roman Chuyan, CFA

March 15, 2020

• Our fundamentals-based process has helped protect against the entire downturn so far.
• Stocks are cheaper, but economic factors are now negative, and so is our outlook for the S&P 500.
• I describe developing themes (earnings, economic) that might continue to pressure markets.

All major stock indexes resumed their plunge and entered bear markets, defined as over-20% decline from peak, thus terminating the preceding 11-year bull market. This is an interesting time, and I have a lot to write about. I’ll cover market trends (some very unusual), and then discuss emerging fundamental themes including economic and earnings.

But first, let me note that we continue to protect our clients against this downturn. The YTD returns in our Tactical Growth and Income strategies are low-positive from interest on short-term T-Bills. Our models gave signals to de-risk well ahead of the market plunge. In retrospect, our models did exactly what they were designed to do – an example of how our forward-looking process protects against a violent selloff such as this, while backward-looking models cannot.

Market Trends

Years of bull market and an accommodative Fed encouraged overinvestment in risk assets – including stocks, but also high-yield and investment-grade bonds. Some took more risk than was appropriate for them, hoping to sell in time. But the warning memo never arrived. Now, many investors heading for the exit at the same time makes this selloff especially steep.

In stocks, “fear indicators” spiked to the levels of previous severe selloffs. The Put/Call ratio jumped to 1.83 on March 9 – nearly the same as its peak of 1.82 in December-2018. Implied volatility – the VIX – jumped to 75 on March 12, previously exceeded only in October-November of 2008. This is real fear.

S&P 500 & VIX, 2006-2020

Corporate and high-yield bonds and loans also dropped sharply, now down 8-9% from their recent peaks (see chart). Expecting bonds to gain when stocks fell, some managers have expressed surprise. They wouldn’t if they’d studied bear markets. While negative correlations hold in a “normal” environment, credit always sells off in severe downturns such as in 2008. That’s why we’ve been holding US Treasuries.

Bond Price Returns, 3 Years

The corresponding credit spreads widened significantly, close to their previous “moderate” peaks in 2011 and 2016 – but not yet nearly to their 2008-09 levels:

Credit Spreads, 2007-2020

Finally, currencies moved in unusual ways. Emerging-market currencies had been falling for some time, and have now plunged to, or near, their all-time lows. During the rout, the Euro and the Yen rallied (the dollar fell). This was driven by an unwinding of hedge funds’ “carry” strategies rather than by confidence in those economies. It appears that the unwinding has mostly run its course.

Fundamental Themes

As I’ve written previously, the problem is not just the coronavirus pandemic, but that it’s happening amid a fragile macro environment. Valuation and leverage were extreme amid slowing global growth and flat earnings. The coronavirus containment efforts escalated quickly, and now affect everyday lives. Travel declined, schools and universities closed or moved online, events were cancelled, and companies sent people to work from home. Apple just announced closing all its retail stores outside China until March 27.  All this puts pressure on economic activity – but we don’t yet know how much. Economic data is available only with a lag. Among early indicators, consumer sentiment has begun to ease only modestly. Our equity model detects weakness in the Houses for Sale data – a similar pattern to that in 2007. JP Morgan now projects a US recession, expecting GDP to fall 2% in Q1 and 3% in Q2.

Economic projections follow markets. JP Morgan’s recession warning could be correct, but it didn’t precede this market plunge – it followed it. To inform our investment thesis, we think about upcoming themes:

Earnings

Companies give guidance in analyst calls at the end of each quarter. Negative guidance was one reason for the market drop in Dec-2018, in my view – earnings began small declines in early 2019 from 13% growth in Q4-2018. Earnings for the current, first quarter of 2020 will likely be terrible. Not only travel and hospitality were hit by the epidemic; energy and materials were hit by plunging commodity prices, but broad weakness is likely across other sectors. This might initiate another wave of selling in late March.

Economic projections

Other major banks will likely follow JP Morgan in uttering the “R” word, which will create more negative sentiment and selling. Investors remember that bear markets set on in recessions.

Institutions

Hedge funds can move quickly, and were likely among the first to de-risk. Currency moves suggest that the carry trade is now reversed, and so are probably most net-long hedge fund strategies. However, other institutional selling has only begun. Trend-following, volatility-driven, and risk-parity strategies have de-risked by around half. Long-term money – pensions, endowments and foundations – tends to shift based on prevailing economic and earnings projections (which are now falling) and to act quarterly (end of Q1 is approaching). This wave of selling will be larger the worse economic and earnings projections look.

Coronavirus

The epidemic has continued to drive market moves ever since it first pricked the bubble. Global infections are now growing at about 10,000 per day. Aside from increased test availability, the quickening or slowing of its spread and any news of development of a vaccine or cure will continue to affect markets.

Finally, I’d like to shift focus to the long term. In my mid-December post Welcome to the 2020’s, I described an environment with lower average returns and higher volatility, and with occasional sharp downturns – and the one now unfolding confirms this thesis. Buy-and-hold strategies worked well during the 2010’s bull market, so it’s understandable that investors didn’t bother with downside protection. We think that downside protection will be critical in the new environment. Looking back at the past month is not really a good reason to begin using us – looking ahead to the next 10 years is.