Buy Stocks or Bye Stocks?

For those who do not know my profession: I'm an institutional securities trader who focuses on short-term market developments but also loves to do research on fundamental macro stories (when I have the time).

To categorize the recent market developments as short-term temporary correction would be a complete understatement. Broad equity market has tanked 35% from highs to lows, different sorts of oil declined by more than 50% YTD and the bond market crashed with such speed never seen before (equities and energy market, too btw).

There are already plenty of other articles, videos and podcast covering these developments, some more detailed, some more trash without helpfull explainations and typical phrases like "Never catch a falling knife.", "Buy when blood is covering the streets.", "Cost-average effect benefits long-term investors." ...

I will summarize different kinds of recent market developments as well as future expectations. We don't have to discuss every little detail that happened within the last three months so I will therefore just focus on March. I do no take personal responsibility for investment decisions that have been executed (or have not been executed) based on this article. I apologize for every stylistic device that may personally hurt you.

The almighty Cost-Average-Effect

Go tell investors who bought the Topix decades ago 30% off its all-time-high (ATH) that the cost-average effect benefits long-term investors. Such advices might sound rational in the short-term especially when markets had massive returns for years but are usually nothing more than just phrases that probably everyone interested in markets already knows very well.

This one is a historic exception ... for now. However, its existence shows us that this can actually happen. Topix fell close to 30% (2881 ~ 2075) before bouncing 17% within two months. The second wave resulted in further declines of 37% and a nasty sideways-declining movement over the following two years.

Investors who bought after the first 30% decline off its ATH have never seen their entry level. Never! All the trillion japanese yens which have been printed since then - and some of those JPYs have been directly used by the BOJ to buy japanese equity ETFs - were not able to lift the japanese market above its 1990 highs.

The "buy EVERY dip" Mentality

After years of steady gains and ample monetary and fiscal stimulus the buy-the-dip strategy has resulted in huge total returns. Nearly every decline of more than 10% in the last decade was a good entry level. 2020 was expected to be supportive for markets due to a partial solution of the US/China trade conflict, an easing FED and a high amount of buyback programs. The corona virus and its dramatic worldwide spread caught many by surprise. A third off its highs many professionals now advise to buy stocks regarding their lower valuation and support of ample monetary and fiscal stimulus.

"The FED is now in control. Buy stocks!" - sell side professionals

Well, that is what they have said in January, too. Is there any value in sell-side advices? I highly doubt. But let us dive into the huge number of actions the FED already does/did, announced measures and their potential consequences.

The FED's recent Measures

• CPFF: buying commercial paper from issuers
• PMCCF: buying corporate bonds from issuers
• TALF: funding backstop for asset-backed securities
• SMCCF: buying corporate bonds and bond ETFs in the secondary market (through a Special Purpose Vehicle)
• MSBLP: lending to small and medium-size businesses
• Federal Funds Rate cut by 150bps (0-0.25) since beginning of March
• $60 Bln Quantitative Easing (QE) per day
• $1000 Bln in overnight repo operation per day

It amazes me how aggressive the FED has reacted in the last weeks. All those measures exceed what has been done in 08/09. The FED's balance sheet has increased by more than $1 trillion within less than a month, rocketing close to $5.5 trillion by end of March. No doubt those actions will have significant effects on markets and the flow of credit. I will summarize - for all of you who are not familiar with the bond and credit market - what has led the FED to act so drastically.

The lack of liquidity, regulation backslaps and risk-parity funds

For those of you who are unfamiliar to what liquidity means: liquidity is a measurement of the ability to sell and/or buy a certain amount of financial assets like stocks, bonds or index funds like ETFs. If you are not able to sell your securities for the price you wish then that's because there is no buyer at that price. Eventually, if you need to liquidate your assets because you need cash to pay your bills - and that's not just the case for individuals but also for corporations - you might have to reduce the price of your offered securities until there shows up a buyer. During market turmoil this can last long and result in huge price swings, on the up- and especially the downside.

A lack of liquidity has resulted in crashes in various asset classes like stocks, bonds and credit. Investors were feared or forced to sell assets due to regulatory rules or individual risk management. At one point this resulted in a rush to exit markets. Everyone wanted to sell their stock, bond and credit positions because they were forced to do so. To understand this behaviour we have to look into what VaR (value at risk) - a common risk metric - means.

Value at Risk - VaR

VaR is a statistic that measures and quantifies the level of financial risk within a firm, portfolio or position. To calculate a VaR you examine the volatility of an asset within a spefic time frame and assume that price swings are normaly distributed. In normal, less volatile times your day-to-day risk is - depending on the asset (class) - little. Let's do an example:

Hedge fund ABC has a $200mln long position in Apple. When volatility is low and Apple's stock moves around 1% a day and assume that the price swing will be around 1% tomorrow, then there is a risk of ABC's Apple position to lose $2mln in absolute value within one day. Because ABC's risk management rules allow them to take the risk of losing $4mln in its Apple position, they can increase their Apple position until the day-to-day risk reaches $4 mln.

Suddenly, something severe happens in the financial markets and Apple's day-to-day volatility rises to 5%. ABC's day-to-day risk of losses in Apple rises to $10mln (assuming a $200 mln position). This is more than double the $4mln which was set by their own risk management rules. Due to VaR calculation ABC needs to cut its Apple position by 60% so that the absolute amount of Apple stocks declines from $200mln to only (max.) $80mln.

These widely used risk management metrics put investors, Hedge Funds, Pension Funds etc. under huge selling pressure at the same time! Everyone is trying to sell assets when buyers almost disappear. A perfect lack of liquidity.

Risk-parity Funds

A risk-parity strategy is an investing strategy that assumes that compound risk can be reduced by building a portfolio with assets that have negative correlation. This is what most risk-parity funds have done:

For many, many years there was negative correlation between bonds and stocks. Usually, when stock prices increased bond prices declined and vice versa. To build a "risk-parity" portfolio a portfolio manager allocates a certain amount to equity positions like stocks and the "remaining" stake is put into corporate and government bonds. This has resulted in attractive returns with less realized volatility (sharpe ratio).

But here comes the little extra: due to general lower total return of bonds vs. stocks, bond positions have been levered up! This is a legitimate procedure when it seems that this negative correlation provides some safety margin but as soon as correlation turns positive and stocks crash the whole power of volatility unfolds.

The close-to-close volatility of a 50/50 SPY/BND (S&P500 ETF and Vanguard Total Bond Market ETF) portfolio surged above levels not seen since the GFC - and don't forget that bond positions have been levered up. Risk-parity funds mistook leverage for genius. History doesn't repeat itself but it often rhymes (LTCM).

Regulation Backslaps

After the massive shocks of the GFC, regulatory authorities added a bunch of new rules for financial institutions. One of those was the Volcker Rule. This regulation restricts financial institutions like investment banks (IBs) in the field of proprietary trading and market making. Inventories of a certain security of an investment banks are not allowed to exceed the "reasonably expected near-term demand of clients, customers and counterparties". This prevents IBs at some point to continue market making. Market making (providing buying/selling liquidity) stops at the point when a position in a certain security becomes bigger than "expected near-term demand". Because risk-parity funds and other market participants were mostly selling assets one of the most important buyer were IBs until they had to stop buying, stop providing liquidity to sellers.

That is why the FED massively increased (overnight) repo operations. The idea was to drain IBs fixed income positions to give them room to provide liquidity for sellers. However, this did not work like expected because IBs somehow refused to take the liquidity the FED was/is providing due to bad experiences with authorities during the GFC.

Repo and Reverse Repo operations ...

Because the tapping up of repo operations did not have the expected effects the FED decided to actively provide the liquidity to the dysfunctional bond and credit market. I have mentioned those measures at the beginning of the chapter (The FED's recent Measures). This has calmed the bond, credit and stock market by preventing further lack of liquidity while some funds still had forced liquidations ongoing. However, this is not the holy grail. Liquidity issues in the bond and credit market have temporarily been fixed but these issues are only the consequence rather than the ultimate cause that needs to be solved.

What is the ultimate cause?

The corona pandemic has caused complete chaos around the globe. I am not close to be an expert in the fields of biology or medicine so I will refuse to give any outlook on the spreading of this virus. I can only imagine the consequences for our economic and financial stability. In the beginning it was only a supply shock due to the lockdown in China that has lead to negative disruption of supply chains but as the virus spread globally with exponential speed soon lockdowns in Italy, Germany, France, Spain, the US, the UK etc. followed.

A perfect deflationary shock. Global money supply will decline when people and companies default on their debt. Don't be too optimistic that the FED and fiscal support will rescue all. The amount of defaults will probably be much higher than anticipated. The support of the bond and credit secondary markets somehow fixed the problem of market liquidity but that does not prevent people and companies from defaulting.

We have seen incredible numbers from the labour market as initial jobless claims surged to record levels (3.283mln vs. 1982's record of 695k). Do not expect this to ease back to normal levels. Do not expect the markets to rise back to the highs just because FED and government officials tell you that they expect huge positive growth numbers for Q3/Q4.

Political and Structural Issues

Economic and financial consequences are already huge but there is also political turmoil. It is 2020 and presidential election at third of November. The economy will definitely face a recession if not depression (hopefully not). Stock market has already erased the gains since Trump's election and that is a pretty tough challenge for someone who praised every new high. Chances for him to get reellected have fallen dramatically in favour of Joe Biden since end of February.

His position regarding bailouts will be key in my opinion. Companies which have bought back stocks instead of building an emergency reserve are now asking for bailout. People are already demanding action against such "parasites". I fear there will be another "Occupy WallStreet" movement if policy makers fail to address this issue. Especially his standpoint on cruise lines which are operating under foreign flags (so not paying much tax in the US) but asking for bailout will be important. He was ellected to fight against the "system", to fight for America and to bring companies back home. He better delivers.

I hope this was in some way informative and entertaining. Still, I don't give advice to invest or to not invest, such decisions are your very own. For those of you who believe the stock market is cheap, that there's a historic opportunity or that the buyback issue doesn't matter, here are some charts: