This blog was written March 19th 2020
The initial 20% fall of the S&P 500 took only 16 days to achieve. During the Wall Street Crash of 1929, it took twice as long. Also, starting on March 12th we saw three consecutive trading days where the absolute moves of the S&P 500 were above 9%, for the first time since 1929. Needless to say, the volatility during the last few weeks have been explosive.
The volatility during the last few weeks have been explosive
The VIX index, which is the most common metric for measuring the expected volatility of the US stock market, hit 82 on Monday exceeding the spike we saw during the Great Financial Crisis of ‘08/’09. As a comparison, the average VIX for 2019 was 13,8.
So, what’s going on and how do we expect this to play out?
Let’s take a step back and put recent events into context
During Q4 2018, the global equities market fell almost 20% from early October until Christmas Eve. Most market participants would blame central banks tightening and a growth scare for this downfall.
Many central banks - led by the US Federal Reserve – responded by cutting rates. The equity market reacted positively and 2019 saw MSCI World up 25% and S&P 500 up 29%. There were at least two clear observations from this rally: First, a lot of the performance during the year came from multiple expansion. For the S&P 500, for example, one estimates that 90% of the annual return came from multiple expansion alone. Secondly, in a low growth world with extremely low-interest rates, companies with growth strongly outperformed so-called value companies.
Anyway, 2020 started as 2019 ended – with a belief that the momentum should continue helped by easing trade tensions between the US and China and improving manufacturing data.
As the Coronavirus was spreading aggressively in China and South Korea, the reaction in Western financial markets was relatively muted. Many hoped that the virus would be contained to Asia and that it wouldn’t become a global issue. Most Western equity markets peaked on February 19th more than 6 weeks after the virus broke out in Wuhan.
When Corona spread to Europe the nervousness really picked up
As the market started to fall and nervousness picked up, the VIX reacted. On February 20th the VIX index was as up 8%, the 21st up a further 10% and the following trading day up 47 per cent!
Why is this relevant?
Because a huge part of the trading that takes place in the equity market is now made up of so-called systematic funds such as vol target funds, CTAs and Risk Parity Funds. These types of funds are run by computer programs and trade on signals. Morgan Stanley estimates that during the first couple of weeks of the sell-off, the systematic funds sold in excess of $400bn worth of equities. There were not many fundamental investors willing to take the other side. Everyone is still trying to make sense of the news flow and potential consequences which led to this incredible velocity of the fall.
We are moving into uncharted economic waters
As more and more countries are trying to contain the spread of the virus by lock-downs the economy is hit by both a massive demand shock and a supply shock at the same time. Large part of the global economy such as travel, leisure, services etc are seeing revenue falls of 80-100% almost overnight due to the lock-down and employees are sent home.
On top of that the oil price has collapsed which is hitting oil-producing countries hard.
All this leaves investors with many questions. How long will the lock-down last? When will the spread of the virus start to slow down? What will be the financial implications of the lock-down for consumers and companies? To what extent will the various monetary and fiscal packages work? What will the crisis do to the credit markets? The list of questions is limitless.
The list of questions is limitless
The financial markets hate uncertainty and right now we are moving into uncharted waters with a lot more questions than answers. Fear is about to be replaced by panic. The trading patterns during the last few days indicate that there are investors out there in dire need of cash. Assets considered safe in times of stress such as gold and certain government bonds are being sold off which could signal forced selling.
So where are we going from here?
Good predictions are hard to find these days, but history can at least give us some framework.
Goldman Sachs has done extensive research looking at past bear markets for the S&P 500. They conclude that bear markets can be divided into three categories:
- Structural bear market - typically triggered by structural imbalances and financial bubbles. Recent examples are the Great Financial Crisis of ’07-’09 and the period following the bursting of the TMT Bubble ’00-‘02
- Cyclical bear market – normally a function of rising inflation and interest rates and falling profits. We experienced this both in the early 80s and early 90s
- Event-driven bear markets – these are caused by external shocks such as war, oil price shock, EM crisis. Recent examples here include Black Monday in ’87 and the EM debt crisis in ‘98
The key here is that different bear markets have very different characteristics in terms of how much the market falls, how long the downturn lasts and how long it takes to get back to the starting point.
Professor Robert Shiller of Yale has collected data on 27 different bear markets for the S&P 500 since 1835 and came up with the following findings:
- Structural bear markets see average falls of 57%, last 42 months and takes 111 months to get back to the starting point
- Cyclical bear markets see average falls of 31%, last 27 months and takes 50 months to get back to the starting point
- Event-driven bear markets see average falls of 29%, last only 9 months and take 15 months to get back to the starting point
We believe it is fair to assume that this is an event-driven bear market triggered by an external shock.
This explains the fast fall, and hopefully a speedier recovery as well when the virus subsides.
As seen from the research, an event-driven bear market is back to their starting point typically within a year compared to four years for a cyclical bear market and nearly a decade for a structural bear market.
What can make the markets turn?
However, there are a few additional points to consider: We have never seen an event-driven bear market triggered by a pandemic before. Nor have we seen a bear market in which the interest rates have been so low (which reduces the effect of using monetary policy as a tool).
In addition, the combination of a pandemic driven demand and supply shock with on an oil price collapse of about 60% clearly puts significant stress on the global credit markets.
As for what could make the market turn, we believe there are three potential triggers:
- That the virus outbreak starts to show clear signs of seasonality or is simply peaking out.
- Some proof that aggressive fiscal policy is working to keep the economy afloat without too much damage
- That the markets overshoot in pricing in a deep and lengthy recession.
For the next few weeks I think we will continue to see very volatile markets, and probably further declines as earnings expectations will be collapsing further. Many analysts are now calling for almost no global GDP growth for 2020 which typically implies a 30-40% earnings drop from current levels.
Consensus has a very, very long way to go in downgrading numbers.
At some point normalcy will return
It is impossible to call the bottom of this bear market, but one thing is for sure:Bear markets like this presents us with many opportunities to buy great companies, with great business models and solid management teams at a bargain price. In addition, in the midst of the panic and forced selling, companies will simply be mis-priced. These are the kind of opportunities we strive to take advantage of as active fund managers. The virus will subside at some point and normalcy will return and when it does, the market is a lot higher than were it is today.
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