by Dr. G. Kevin Spellman, CFA
- Human behaviors are following predictable patterns in response to coronavirus
- Markets are not functioning correctly – is Financial Crisis 2.0 brewing?
- Expectations started high, so the sharp correction is not surprising
- A recession could be needed to rid of excesses
- Maybe we should just stay home and watch Netflix
So much is happening, and quickly. The S&P 500 is down almost 30%, schools and businesses are closing, people are beginning to panic, and the financial markets are not functioning smoothly (stocks and safe assets are both declining). Monetary and fiscal policy are coming to the rescue, but maybe we just all need to stay home.
Behaviors are Predictable
This is predictable. The human behavioral side anyway. Recall my Expectations Clock (PhD thesis).
- The Expectations Clock: People under-react to negative signs (what was happening in China) during good times. During bad times, people over-react to negative conditions (the attitude is just do something/anything). We are almost there. We need Trump to get there (to over-react or at least react more than so far) before the market bottoms.
Bill Ackman (famous investor) said on March 18th that to get the market to bottom we need to bring out the National Guard and stop the economy a month. I agree, and I wrote about this (staying home for a month) a couple weeks ago as a way to lead to a peak in the virus. However, I expected the US would be slow to do what China did (stop it’s economy/keep people home), and this has so far been a correct call. An extended period where we allow people to go out will lead the market down further as businesses stay partly closed for longer. This could lead many to fail. On the other hand, those businesses may be able to get by without a month or two of sales, especially with government support.
In my opinion, and this is based on studying human behaviors, it will take more pain for Trump to shut down the economy like China did. He may be still somewhat anchored on his original thinking (that this is not so bad) and stating this publicly (so he has to admit he was wrong) that he has this under control. He may change his opinion slowly since he appears to surround himself with “yes men” and, like almost everyone who does my confidence survey, is overconfident. It is even harder for politicians (any party) to change their opinions because unfortunately, doing so is considered weak. I disagree with this. Changing an opinion is being strong. Keynes said, “When facts change, I change my mind.” Great words.
Thus, the market will continue lower and spreads will widen further until Trump goes all in to stop it (shuts down business). He probably eventually will, as he wants to be re-elected. Messing this up could very well cost him his election (people like to attach the economy and a crisis to a person, and Trump will likely be that scapegoat whether or not deserved), and I expect we can count on him to do what is best for himself. Self-preservation is a bias everyone has, so don’t take my comments as being political here. I am just discussing normal human reactions.
The current reaction is also predictable even if coronavirus becomes something that was overblown (it is less deadly than MERS, SARS, measles, etc.). If one firm closes and others stay open, the one that is open is not chastised. However, if 10 close and yours is the only open, then you are considered irresponsible and don’t care about your employees. This is because people herd. They feel safe doing what others are doing. Thus, all will eventually close.
As Ackman noted in his interview on CNBC on March 18th, the bottom of the market could be when the National Guard comes out and everyone is ordered to stay home. Then the rate of transferring the virus from person to person (R value) will drop to less than 1.0 and this can go away. One month lost to all businesses is way less damaging than many months in a partial shutdown.
Is Financial Crisis 2.0 Here?
We have financial crisis / liquidity crisis 2.0 brewing.
What is the safest asset? Many would say gold, but it was down today and last Thursday in a down market. Ok, then US Treasuries, but they were down as well. What is going on?
Everyone needs the cash. People are selling even safe assets.
- Due to new financial regulations (Volker Rule) after the financial crisis, banks cannot hold an inventory of bonds. This means that if a person wants to sell a bond, a bank cannot buy it and then later find someone to sell it to and perhaps make a profit. Holding securities inventory that went down helped cause banks to go insolvent during Financial Crisis 1.0.
- Some bonds do not trade for months. So, if banks cannot buy from a seller, we needed others to step in. Those others include hedge funds and investment companies. Hedge funds are loosely regulated, and they are providing liquidity (cash) to the markets. This is what I learned from Scott Buchta, head of fixed income strategy for Brean Capital, last Friday.
- (Warning: I am stretching my understanding with what is going on by making this point, but I expect I am at least mostly correct and it is important so I am willing to expound here.)However, where does the hedge fund get its money? Investors and banks. If banks are worried, they require hedge funds to put up more capital to buy bonds from sellers. For instance, what if banks used to lend $800 to hedge funds to buy a $1,000 bond from sellers. The other $200 was provided by the hedge fund investors. Now, since banks are tightening credit, let’s say they require hedge funds to put up $600 in cash for the $1,000 bond, and only lend $400 but at a higher rate. If hedge funds don’t have more money from investors, they cannot buy the bond and bond prices fall. THIS APPEARS TO BE HAPPENING. On top of this, investors may be withdrawing assets from hedge funds, which compounds the issue.
- The Fed stepped in over the last week to provide cash to banks / corporations in a host of ways. The hope is that they will supply this to corporations and to those investors (hedge funds) who are providing liquidity to the bond market. Obviously, it is not working yet.
On top of questionable functioning bond markets:
- We have risk-parity firms unwinding. Assume to achieve a risk target that the funds allocated 50% to equity and 50% to bonds. If stock volatility rises, the funds must sell stocks to buy bonds (assuming they are less volatile) to maintain their risk target. This means that stocks that are down must be sold. We have a lot more of these types of firms than years ago and this can be exacerbating market movements.
- Meeting margin calls on levered positions are probably leading to large moves in markets as well, and those investors could be selling the most liquid assets (gold and US Treasuries) to meet the calls.
- Of course, computers algos could also be driving markets to extremes.
- Where are the more rational investors? Well, many of them were fired. Many fundamental investors (active managers) have been fired to hire low cost indexers and they are no longer available to provide liquidity (buying) in those stocks that are down most.
Market Expectations Began High
OK, I have to make matters seem even worse. So sorry.
The amount of corporate debt in publicly traded markets is high, and the amount of debt to value or sales for corporations is very high (I’ve shown the ratios in prior posts). Plus, a bunch of this debt is bound to be downgraded to junk in a recession as triple BBB debt is worse off (worse credit ratios) than in the past (see slide 35 of this presentation). This means that corporations are levered up at a time when there are fewer willing to lend and when public debt markets are not functioning well.
Furthermore, private equity markets are also levered up (according to Bain & Company, at the end of 2019 about 75% of deals were at 6X/EBITDA vs 20% after the financial crisis, but there is a lot of dry powder ($2.4 trillion) according to PitchBook), money has been flowing to momentum stocks that became ever richer in value, and venture capital has received ample funding. Money moved to these assets as people pushed up the risk spectrum due to lower and lower rates from “safe” bonds.
Did the Fed induce this corporate leverage bubble? It solved the financial crisis by allowing people to borrow even more at lower rates? On top of this, the longer and stronger the cycle, the more people forget risks. To go back to where I started, people under-react to negative signs when conditions are good. A bubble was brewing and is now bursting.
The last financial bubble was created by too much bank and consumer debt. This cycle ends with too much corporate debt in a debt market that is not functioning well. Corporations employ individuals, and much of this employment is in small highly levered businesses. If they go under…
Besides the bond market, equity markets and options markets started the year with high expectations (see Economy Caught a Nasty Virus for charts). Earnings were expected to rise 10% this year. Coronavirus caught markets completely off-guard, which explains the rapid correction that has set records.
I’ve thought for over a year that we needed a recession to rid of excesses noted above, so maybe what is happening is a little bit less terrible if it gets businesses and investors thinking more rationally (after the current panic).
More Bad News and a Positive (Sort of)
My father, a very good investor, made a good point to me earlier today. Even if we close the doors to business / make people stay home for a month+ to get the R value to less than 1.0, if the majority have not had coronavirus then they could just get it later. Maybe then we’d only get a breather this summer before things fall apart again this fall if we make everyone stay home now. Well, at least then we will be closer to having a vaccine.
Let’s end with a positive. Fortunately, we are now down almost to the S&P 500 level we were at in December 2018 when we thought there could be a recession. We are also 3% from matching the average correction during the last seven recessions. Although, recessions that started bubbly (like this one) went down more. Comparisons to prior recessions may also be less relevant as this situation is new, which also makes it scarier (at least I tried to end positively).
For more commentary from Coach Kevin make sure to check out his webpage HERE