CREDIT MARKETS SAY LEHMAN MOMENT MAY STILL BE IN STORE
Note: The ICE Bank of America US High Yield Index Option-Adjusted Spread closed at 9.82 on 3/19/2020.
Focused And Flexible
GOVERNMENT STIMULUS PACKAGES COULD SPARK RALLY
We have a wildly oversold market that is, by historical standards, overdue for a 10-20% rally. It is possible the third bill making its way through Congress could bring back some buying conviction. From CNN:
Senate Republicans are racing to reach a GOP deal on a massive $1 trillion economic stimulus as the coronavirus crisis intensifies, despite facing criticism from Democrats who warn that efforts to swiftly pass a stimulus could be derailed if they are not included in negotiations now.
Senate Majority Leader Mitch McConnell on Wednesday said Republicans are "getting close" to a deal and has outlined a plan that would involve Republicans coming to an agreement before going to Democrats in an attempt to forge a bipartisan consensus.
In a sign of tension between Republicans and Democrats, however, Senate Minority Leader Chuck Schumer criticized the way that Senate Republicans are negotiating on the economic package on Wednesday, calling for them to do more to include Democrats.
After the market closed Wednesday, the ECB announced another in a long series of stimulus measures from policy makers around the globe. From FX Street:
ECB says to launch a new temporary asset purchase program of private and public sector securities to counter the serious risks to the monetary policy transmission mechanism. Says purchases will be conducted until the end of 2020 and will include all the asset categories eligible under the existing asset purchase program.
SHORT-TERM DEVELOPMENTS WORTH NOTING
During Wednesday’s session, the S&P 500 dropped below two levels noted on Twitter and then rallied intraday to close back above them. The 38.2% retracement for the 2009-2020 bull market sits at 2351, which is also the S&P 500 closing low on December 24, 2018. The market closed above 2351 at 2398.
There was also some “be open to a rally” evidence from some expected volatility readings. The standard VIX is still sitting at concerning levels, was green Wednesday, but was relatively tame given the broad range and significant drop in the stock market. It was the drop in one-month volatility expectations relative to three-month volatility expectations on Wednesday that says “stocks may try to get off the mat Thursday” (see graph below).
Many bullish setups have seen no follow through in recent weeks and those that have been followed by a green session have all turned out to be single session events. As of Wednesday’s close, the 2020 market has shown next to nothing.
TRADITIONAL SAFE HAVENS HIT AGAIN AS STOCKS DROPPED
As a money manager, when you wake up and see futures that point to a big drop in stocks and you have a big allocation to cash, bonds, and gold, you expect those portions of the portfolio to be green while the stock side is red. That was not the case for bonds and gold again Wednesday. From Bloomberg:
Some of the winners being dumped may include super-safe Treasury bonds, which might help explain why their rates are jumping (bond yields and prices move in opposite directions), which isn’t what you’d expect in a doomsday-prepping scenario.
The pain in traditional safe haven bonds is not limited to the United States. The Bloomberg text below relates to the experience in Europe:
“This is hard to rationalize given one would tend to think that risk aversion should operate as a zero-sum game wherein safe havens such as German bonds are the beneficiaries,” Rabobank strategists including Richard McGuire wrote in a note. “Investors appear to be pricing in a sizable budgetary deterioration throughout the euro area.”
Rabobank noted that even in previous times of trouble, such as the dot-com bubble and the euro-zone crisis, German bonds rallied due to the consequential haven demand -- unlike now.
“It potentially speaks to the gravity of the situation prompting investors to take a much more narrow definition of what is safe,” the strategists said, adding poor liquidity could also be interfering with the market’s signals.
THIS PLUNGE SIMILAR TO…
The S&P 500’s 28-day ROC closed at 28.32 today. The only other periods in the S&P 500’s history that featured a ROC that hit that level were 1987 and 2008. In both cases, a sharp countertrend move occurred. In both cases, the pop was retested in some manner. The 1987 case helps with the “a bottom could be starting to form now” end of the spectrum and the 2008 case helps us with the “we could still drop over 25%” end of the spectrum. In both cases, really good things eventually happened on the other side of the fundamental and volatility event.
MORE VOLATILITY EXPECTED
The standard VIX closed at 76.45 today. That represents an extremely elevated and extremely rare reading for volatility expectations looking out 30 days. We will enter Thursday’s session with an open mind and see how it unfolds. The term “unprecedented” can be used to describe numerous bearish events in recent weeks. We could view unprecedented events with a negative mindset or we can respect unprecedented events in the financial markets require unprecedented focus and determination if we wish to navigate to the opportunities on the other side.
This post is written for clients of Ciovacco Capital Management and describes our approach in generic terms. It is provided to assist clients with basic concepts, rather than specific strategies or levels. The same terms of use disclaimers used in our weekly videos apply to all Short Takes posts and tweets on the CCM Twitter Feed, including the text and images above.
Credit Spreads Reach Rare Heights
MONDAY AND TUESDAY’S SESSIONS
Credit spreads speak to economic and financial system confidence. Widening spreads mean market participants are growing increasingly concerned about an economic downturn and increasing odds of bond defaults. We covered spreads Sunday evening and as you might imagine they widened again during Monday’s extremely rare risk-off event. From the Financial Times:
”The S&P 500, the benchmark for the US equity market, lurched lower in the final minutes of trading Monday, eclipsing the worst performance of the pandemic and marking the biggest single-day loss since the crash of October 1987. The tech-heavy Nasdaq Composite had its worst day ever, down 12.3 per cent. The CBOE Volatility index (VIX), the market’s “fear gauge”, jumped to a record high.”
Spreads have reached levels that may help us differentiate between the four cases shown below. The top row of the table shows the extremely rare spike in spreads that took place between February 19 and March 16, 2020. Spreads closed Monday at 8.38, a level reached in only four other periods based on data going back to 1996. Notice how the change in spreads looking back 26 days was significantly higher in the current case, even when compared to high-stress periods in 2000, 2008, 2011, and 2016. The spike in the current case could lead to some unexpected surprises when companies begin to roll over debt at the end of the first quarter.
How did stocks perform after concern in the credit markets reached similar levels to what was seen during Monday’s risk-off event? It was somewhat of a mixed picture but it is possible that credit markets may help clear that up in the coming days and weeks. The highest reading during the 2020 event is thus far 8.38, which is very close to the highest readings posted in 2011 and 2016. Thus, if credit spreads exceed 9.10 and 8.87, the odds of an imminent low in stocks will diminish and the odds of a more concerning 2000 or 2008-like decline in stocks would increase (based on the historical cases).
We will continue to track present-day data to try to discern between “imminent low” odds and “a lot more downside in stocks is ahead” odds.
TUESDAY’S SESSION
It is too early to say what Tuesday’s rally in stocks means or does not mean. If it is another one-day bounce, it means little. If the market can continue to rally for a time, it would be easier to remain open to the concept of a bottoming process. From Bloomberg:
“A bear market does not preclude rallies,” said Eleanor Creagh, market strategist at Saxo Capital Markets. “The biggest rallies can be in bear markets -- erratic swings are exacerbated by the present high-volatility regime and strained liquidity conditions. With VIX remaining significantly above the long-term equilibrium, alarm bells are still sounding and traders should be wary of relief rallies.”
We have specific things we are looking for to help identify a potential bottom/bottoming-process and we have several “that is not what we want to see here” items to look for as well. It is best to wake up every day and see how the data evolves.
More information about the current market can be found in Saturday’s and Monday’s posts.
Walking Forward
1987 AND 2008
We have seen numerous data sets in recent days that align with 2008 and 1987. Another example surfaced after today’s close. The present day VIX is based on a “new methodology”. Since there is more historical data for the original methodology, we used VXO for this comparison.
The intraday high for VXO was 95.56 during today’s selloff in stocks that featured a drop in the Dow of almost 13%. Drops of that magnitude in one day are rare. As you might imagine, Monday’s VXO readings were rare as well. An intraday VXO reading of 95.56 or higher has only gone into the history books during two other periods (2008 and 1987).
In the image above, notice how the 2020 rate of change (ROC) in volatility expectations is much more similar in the 1987 case relative to the 2008 case.
HOW DID STOCKS PERFORM WALKING FORWARD?
As shown in the table below, the 1987 case was close to the final low in terms of price, but it took an additional 46 calendar days to register the final low. The 2008 case was quite a bit more painful and featured an additional S&P 500 drop of roughly 25% from the S&P 500 level on October 10, 2008. In the 2008 case, it took 150 additional calendar days to reach the final March 9, 2009 low. In both cases, a sharp 2-3 day countertrend rally occurred with gains ranging between 11% and 15%. Therefore, even if the market has further to fall, we should be prepared for another wild swing to the upside in the days ahead.
In the 1987 case, the low was successfully retested weeks later. In the 2008 case, the retest of the low failed and was followed by months of additional pain.
THESE CASES SAY WE MUST REMAIN VERY FLEXIBLE
If 2020 turned out to be more similar to the 1987 case, then it would be extremely important for us to respect that major lows are typically made before the fundamental issue is in the rear view mirror. If 2020 turned out to be more similar to the 2008 case, then we must continue to be diligent regarding principal preservation. Both scenarios must be respected walking forward.
At some point in the future, an excellent entry point is going to present itself. Those who remain diligent, focused, and composed will have much greater odds of getting properly aligned with that opportunity relative to those who are frustrated, fearful, and undisciplined. The choice is ours to make.