March 9th, 2020: Black Monday - Why Did Markets Crash, COVID-19 Not The Issue, & What Is Going To Happen Next? What Should I Be Doing?

BLACK MONDAY!!

Markets closed for 15 min to avoid panic selling! Dow drops 2000 points, S&P 500 down 7%, Oil prices drop over 20%! TSX drops over 10%, trading halted!

No, this is not like Christmas! Things are not are sale!...or are they?

Take a step back and calm down...it already happened in the overnights session over the weekend before markets opened. The focus is on what to do now vs what to do next.

Stay calm. Take a deep breath and relax. I sound more like a therapist saying this, but it's what you need to do when you feel the panic and anxiety set in.

Now, let's get to it. I'm going to break this down as simple as I can so a 12-year-old can understand.

If you're currently a long term investor in the markets, turn off all business news and walk away, stick to the plan, it's not time to panic yet, I'll explain why shortly..just ignore the noise and media, stay away from CNBC and Bloomberg and don't let the fear-based headlines get to you.

If you're are a short term trader, close our speculative positions that you're in based on momentum, because when momentum turns like it did this Black Monday, the downside risk just isn't worth it. What I'm referring to here are the companies that you don't necessarily believe in holding long term, or don't have good balance sheets, are typically overvalued, and/or are just short term momentum plays for quick gains. 

For all of you that have been waiting for years to buy the good stuff or should I say the creme de la creme of the markets, now is a great time to START MAKING A LIST of all the stock and companies you've wanted to buy for a while, maybe even years, but haven't been able to get a good price because of the non-stop rallies.

Be assured, this selloff will provide ample opportunity to enter positions and buy these stocks at a reasonable valuation. 

As all market events in the past, the near term is scary, it's like watching a car accident or train wreck, but it's important to use this as a gauge for your own risk management.

Step one, get out of positions that have a risk of falling more drastically. Hospitality and Tourism related stocks are a no-no for now, for example. Stocks with small market caps I would also get out of or stay away from for now.

So back in 1987, we had a market crash where stocks went down about 20 % in a single day, and within 2 months markets recouped all of those losses.

So if you are someone who can sit this out, turn off the news, go about your day, as a long term investor, and wait a couple of months, there is a significant chance markets will rebound and it'll be like this almost never happened. 

The last thing you want to do, is panic, sell everything, thinking things can only get worse, actually REALIZE all the losses, and then miss out on potential opportunities because your emotions got the better of you. It is a great time for those that are sitting in cash. I would slowly and methodically start entering positions while setting strict daily/weekly limits so you can Dollar-Cost-Average (DCA) into your positions.

OK. Now that we got that stuff out the way, and you're a bit calmer about the current situation, let's talk about what is actually happening! Let's get this whole COVID-19 situation cleared up. IT's NOT THE CAUSE OF THE MARKET MELTDOWN! (I'll explain that after this)

First things first, COVID-19.

The Coronavirus (now COVID-19) first showed up in China around late fall 2019 and starting getting really severe around December and January 2020. Those most prone to die are the elderly and young infants, naturally, as with any other sickness, virus, or disease, as they tend to have weak immune systems that can't necessarily fight the bacteria. The elderly with pre-existing medical conditions are obviously also more prone to death as an outcome.

Don't listen to the media and pay attention to these headline-grabbing titles, articles, or media personalities. It's NOT the end of the world. THIS IS NOT A PANDEMIC. THE HUMAN RACE WILL SURVIVE. The world is not coming to an end, COVID-19 is NOT causing another 2008 crisis, there is more too it than meets the eye.

Remember, you haven't lost money until you hit sell, these are all unrealized losses in the sea of red, so no need to panic sell or trade reactively, like doomsday is coming. 

What's happening right now is a market situation, coronavirus has very little to do with the bloodbath in the markets. A lot of people including the media are out here spreading fear as if the Coronavirus is a pandemic, like the Spanish Flu post WW1, which killed at least 50 million people, which is far from the truth. COVID-19 is not anywhere close to the same thing, and in this modern era of 'fake news' it's understandably difficult to tell fact from fiction, so stop getting your news from social networks and get it directly from Health Organization.

Now take this in, this figure is just between China and America, not including the number of flights that go between Canada and China or Europe and other parts of Asia and China.

China has about 80 commercial airplanes flying between the US and China every day. Commercial airlines. 80 planes. every day. COVID-19 undoubtedly made its way to North America and probably many other countries months ago. Don't be fooled by the media. World organizations obviously wanted to reduce the risk of mass panic as much as they could until they had a solution, but the outbreak was too much to contain. It's probable that many people already had it, maybe thought it was the flu or just a bad cold (symptoms are similar) and fought it off. About 80% of people who get it, there is no need for EXTRA medical care, and again it's just very dangerous for the elderly, specifically those with pre-existing medical conditions or young infants with weaker immune systems. 

IF this WAS going to be a global pandemic that was going to wipe us off the face of the earth, it would've happened already. We would've seen millions of people die already. So that myth needs to be put to rest

So, that leads us to the BIG question. What is actually happening in the markets? Why is this sell-off happening? 

You'll need a bit of the backstory to understand what's happening, let's dive into it.

If you wind back the clocks to 2018, near the end of the year we had a really nasty market sell-off. The market just took a deep plunge and lost about 20% over the course of about 6 weeks. That situation was caused by the Federal Reserve draining too much liquidity from the system. This really freaked the Fed out as they didn't think the market would be that heavily impacted by the liquidity draw.

So you fast-forward to 2019, toward the end of the year, and now the Fed is terrified they could cause another one of these market collapse situations like they had the year before in 2018 and so they started launching all these diff programs to provide liquidity to the financial system. 

In 2019, there were 3 interest rate cuts in the U.S., a $60 Billion Dollar per month QE program, and then there were these repo programs.

Without getting too technical, in a nutshell, think of the repo market like a pawn shop (For lack of a better analogy right now). The owner has cash, lots and lots of cash is looking to put it to work overnight or for like a week max. The customer has an asset, like a diamond ring, but no cash. The customer needs cash now. so these two essentially make a deal. The customer will give the ring to the pawnshop owner for some cash, with the promise to buy back the ring the next day at a marginally higher price (think of it as an interest). They do this every day, with some assets held for a week some held overnight, and both parties are happy with the outcome. The customer gets to borrow cash for their needs overnight, and the pawnshop owner gets to buy the customers assets for price X, and sell it back to the next day at a price higher than X.

The repo programs are what we need to focus on. This is how we ended up here.

If you're a hedge fund, financial firm or bank, by law you're required to keep a certain amount of your assets in cash or cash equivalent instruments like short term treasury bills or money market instruments that you can just dump and turn into cash because they are liquid enough to do that.

The problem is, hedge funds and a lot of financial firms have used tremendous amounts of leverage (so they've borrowed a lot of money) and they've invested that money into assets, whether it be real estate or stocks, or what have you. However, because they've done that, they are falling below their cash requirements to stay compliant.

So this is the problem...what they do is, they then go to the Federal Reserve and they say, "Hey, If I give you some of these assets I bought to hold overnight or for a week or some short period of time, will you give me cash in exchange for them so that I can maintain my cash requirements, without actually having to hit the sell button and dump these things that I own?" (same as the pawnshop example above).

The Fed then said "Sure, that's fine. We'll do that. we don't want another crisis with large selloffs due to these liquidity requirements."

THE PROBLEM WITH THIS IS...it sent a message to everybody that the Fed was willing to basically allow leverage to get even crazier!!...

If you know you can go to the Fed, and you know you can exchange assets for cash anytime you like, you're going to start buying like crazy, and leveraging up, and buying some more. This is why, starting in the last few months of 2019, the market started to skyrocket...its been going up and up and up, breaking all-time highs, climbing higher and higher, without any real significant correction. 

So you fast forward, and the FED has realized that it's made a mistake, it's created this little mini-bubble in the markets, and it stopped. So around Dec 2019/Jan 2020, the Fed says it's going to start pulling back on the repos, It's going to stop providing all this free cash to these hedge funds and financial institutions...THAT is what largely got us into this situation...where there was just about 3-4 months of froth building up in the markets, then the Fed comes in and says "Hey, we're going to take away the punchbowl."

That's why you're seeing the markets take a nosedive and go STRAIGHT down, without a staggered correction. 

Coronavirus or COVID-19 is just the excuse or the narrative the media is coming up with to strike FEAR in retail investors, either by design or just from not knowing what actually happened. I mean anything coronavirus is a headline that people pay attention too...it's like an optical illusion. You have the media as the magician, running this optical illusion that's mesmerized the population and now everyone's running around saying the coronavirus is leading the next recession...when in fact there is more too it than meets the eye. Fake news spreads faster than real news in today's world, it's just the reality we live in.

Don't get me wrong, of course, there are stocks and industries impacted directly and indirectly by COVID-19. For example, manufacturing in China has slowed down due to the virus outbreak, causing global supply chain delays. You have airlines, cruise lines, hotels, among other hospitality and tourism industry-related stocks that are definitely impacted by this because no one wants to travel, or stay in hotels, or be as mobile as they were when CO-VID -19 didn't exist.

However, when we talk in terms of the broader market, we start to get this really nasty meltdown because the Fed started taking away the punchbowl, that it shouldn't have put out in the first place, and a lot of these big institutions that hold market-moving positions, now are forced to sell to meet their cash requirements. You don't get market selloffs and nosedives like this Black Monday, from people like you and me going to a brokerage account and hitting sell because of some kind of Coronavirus panic or fear that the media created. We don't have that kind of power.

These happen when the big guys, who manage billions, have to sell everything or large positions, to meet these cash requirements and the Fed is not budging on giving them free money anymore. 

We need to step back and look at this and see how this affects the rest of the economy. So we turn our heads to the credit market and this oil crisis that is now underway!

Leverage levels are high, there is the danger of a credit event, but it's still so early in the game, that's we're not near the levels where everyone should panic and sell everything!

Let's take a look at what's going on in terms of the credit market. So Saudi Arabia and Russia, came to a truce in 2016 that they were going to start cutting production of oil. They did this at a time when globally it seemed like there were these systemic risks and they were essentially just trying to stabilize the system.

So we fast forward to today...and Russia has noticed that oil is falling and has been hanging around USD$50-$60 a barrel. Now the US shale industry, which Donald Trump is very proud of, and has made the US energy independent, requires oil to be at about $60-70US a barrel to be profitable. 

So Russia saw the situation, sees that it's an election year, and sees that this could damage the US economy, and pretty much says we're not going to do production cuts anymore, we're going to start pumping out as much oil as we can. Saudi Arabia sees this and goes, ok..so we're also going to pump out as much as we can! Now, this is kind of a game of chicken between Russia and Saudi Arabia because they both need oil to be at certain prices to finance their entire economies. The reality is, Saudi Arabia has a lot more cash and reserves than Russia does. So Saudi Arabia, which is one of the US allies, is essentially trying to call Russias bluff..get them to back off...and get oil prices to go up again..but in the near term, what this did over the weekend was, oil collapsed 30% because you suddenly have two of the biggest producers pumping their brains out saying a lot more oil is coming to the market, so oil prices are obviously going to fall. 

The problem with this in terms of the credit cycle is that there are about $10 trillion dollars in corporate debt in the US financial system. About 1.5 trillion of that is what we call junk debt or junk bonds in the financial world, meaning this is debt that has been loaned to companies that are risky, financially unstable, and highly likely they are going to go bust if anything goes wrong. Of that junk, a significant percentage is financing American energy shale companies.

So this is where it starts getting scary. 

You have the market meltdown which just hit because the market doesn't like surprises and this thing from Russia and Saudi Arabia has caught the market completely off guard. No one saw this coming...the market destabilized and dropped.

Now the bigger question we need to ask ourselves is, with the oil price dropping like this..is it's going to cause a mini-crisis for the oil and shale industries in the US? and if that happens, is that then going to start spreading throughout the credit market with defaults?

The credit markets are kind of like the mortgage markets in 2008. The junk debt would be like the sub-prime mortgages 2.0, and then you've got the stuff that is not quite rated junk, but is close to it..but still on the side of investment grade. The rating companies play a big role here, because if the stuff they are rating as investment grade, is actually just crap in disguise, then essentially we could be on the verge of another financial meltdown. 

If you remember from 2008, the crisis that happened then, was not really sub-prime mortgages but when the stuff that wasn't considered sub-prime, started to turn out to be sub-prime too! The stuff that everyone thought was pretty good and turned into various instruments by the financial institutions turned out to just be loads of garbage. That's when the system fell apart. 

What Do I Do Now?

What you should be looking at now is if the drop in oil price is going to trigger a wave of defaults from the oil and shale companies. That would be the first clue or sign that things are going to get much worse. 

What would be REAL BIG TROUBLE, is if that starts to spread across the wider credit market, and things that are on the verge of junk or just barely investment grade, start defaulting as well.

With $10 trillion dollars in the credit market, with 1.5 trillion junk, and another maybe 2.5 close to junk but not quite junk, you're looking at about 4 trillion dollars or 40% of the credit market at risk here. 

If that starts to blow up, it's a really big problem to manage. so if you see signs of this starting to happen, then it's time to forget what everyone says about keeping calm, weathering the storm, and all that stuff, and its time to realize that this is another 2008 crisis on our hands. Run for the hills. 

For now, it's 'watch and wait' mode, to see how this affects and trickles into the credit markets because THAT is going to be what determines where this goes from here! 

Now, to see if we're in the clear or in crisis mode, from an average investor's perspective, this is what you should be doing.

There are a couple of ETFs you should be paying attention to get direction on the market.

Start following the JNK and HYG ETF tickers.

You want to pay attention to these ETFs because they track what I've described as junk debt or junk bonds earlier. Watch the charts and you'll see them falling rapidly, but they are coming up on what we call support levels.

Support levels are typically the lower levels where these things typically bounce back up. They indicate a lot of price action, sort of like an indicator of where people like to BUY these things at. If we a slice through that support level on the lower end, then start getting worried. If it holds that support, bounces back, and stabilized, then it's not that worrisome, as it may indicate this whole market situation will just blow over. It may ugly, volatility will be high over the next few months but it's bottomed out and it'll stabilize. 

What you should also be waiting for is to see how the Fed and Trump administration responds to this. In 2008, the Fed got aggressive and it put a floor underthings. Now, in this instance, it's a bit more difficult, cause the Fed was already cutting rates, the Fed was already doing QE (even though they argue it wasn't), and they were already doing these repo operations as I mentioned earlier. So they would really have to get creative and aggressive. The Trump administration is considering its options whether its tax deferment, another tax cut, a new infrastructure program, so if credit market gets ugly and the U.S government steps in, in a big way, and provide enormous amounts of economic support, you could see this thing find a nice bottom, and rally back to all-time highs. 

We'll need to wait and see how it plays out but the stage is now set for the next act.

I hope you found this insightful and easy to follow or at least learned something new!

Vakeesan Mahalingam, CFA CBP