Observations After a Week That Ended with a Thud

There’s no way to sugar coat it: Friday was a lousy close for the S&P. Option expiry (as written about in yesterday’s post) likely amplified realized volatility in the cash markets. Some previously deep OTM put options were brought near ATM by the speed of the drawdown, so there was a significant incentive for hedgers to protect those profits by pushing around spot in liquidity-impaired markets. 

Additionally, the prospect of working from home (“WFH”) with its suboptimal trading conditions likely fed the desire to accelerate risk shedding ahead of a weekend that most feared would abound with disturbing COVID19 headlines. The S&P took out the important 2352 December 2018 support on a close for the first time. Although futures volume was the lightest of the week, cash volumes for the S&P were the highest since 12/24/18 market bottom; those high volumes validate this move lower, so it must be taken seriously. There will certainly be a temptation to draw a parallel to the volume-driven capitulation low that occurred on Christmas Eve, 2018. However, one only recognizes these capitulation bottoms in hindsight. Furthermore, the takeout of a key support level with Friday’s close caused meaningful technical damage. This could imply more pain to come by potentially opening a move to around 2136, which marks the resistance top of the 2015 systematic unwind episode; that would be another -7% down from the Friday close.  

That 2015 support level (broken resistance) was created amid a prolonged sideways chop, which built a congestion zone on substantial volumes. This support level is the top of a broad consolidation range with 2136 as its top and around 1810 as its bottom. The bottom end of the range should be seen as very strong support as it is a level formed by the 2014 reaction low and the 2016 double bottom off of which the bull market resumed for another four years. It unfortunately also means we may have to test that bottom end of the consolidation range to establish a point from which to reverse. The additional -20% down that reaching that critical support implies would make this bear market more dramatic in velocity and ferocity than any historical precedent. Those who have been reading my posts know that I had been calling for a countertrend rally within a more substantial, longer-lasting bear market. I may have been early in my call for a market bounce. I have been using the 1987 and 1929 episodes as crude yardsticks by which to judge what could be the magnitude of the current market crisis. As Mark Twain famously said, “history doesn’t repeat itself, but it often rhymes.” This drawdown has exceeded the 1987 experience in about half the time. Using the 1929 experience (looking at market top to local low) would imply a further 18% drawdown from the 03/20/20 close which would put us at roughly 1890, above the 1810 bottom level I mention above. This gives a sense of a wider support range for a market that now is toeing for solid ground on which to make a stand.  

Beyond the charts, there are some market structure similarities with both of these historical episodes. In 1987, portfolio insurance, which employed futures hedges to offset losses in cash markets, created a self-reinforcing effect that gained momentum as the market moved lower. This is not too dissimilar to the current market environment in which the aggregation of assets in procyclical investment strategies has created a severe risk transfer disequilibrium. I wrote about this more extensively a few weeks ago here:(https://www.dhirubhai.net/posts/christopher-tackney-cfa-805b992b_risk-transfer-disequilibrium-liquidity-activity-6641516392371761152-OCex). As for the 1929 experience, I will leave aside the economic structure along with the actions of both the federal government and the Federal Reserve which compounded the economic crisis. In searching for parallels to the 1929 market structure, I have come across one feature which bears some resemblance to what we have today: investment trusts. “The investment trust did not promote new enterprises or enlarge old ones. It merely arranged that people could own stock in the old company through the medium of new ones…it brought about an almost complete divorce of the volume of corporate securities outstanding from the volume of corporate securities in existence.” (The Great Crash of 1929, John Kenneth Galbraith) These vehicles often employed a high degree of leverage. When the underlying shares began to sink, this amplified the downward momentum. All of this does not sound unlike the current ETF market environment. An additional similarity is that many ETFs employ leverage to “enhance” returns on the underlying assets. Doing a quick scan of listed leveraged ETFs, I see aggregate assets outstanding of $25B with leverage on average of around 2.5x. It is worth noting that these include both long and short levered ETFs. 

This gives a sense of how market volatility can be magnified via these products in a similar way that investment trusts did in 1929. A key difference between investment trusts then and ETFs now is transparency. In 1929, many of these vehicles were blind trusts, and some of the assets they held were shares in other trusts, which were themselves levered. Today, ETFs have transparency of assets that investors can see daily. What is not transparent in ETFs today is the mismatch between trading liquidity of the underlying assets and that promised by the ETFs themselves. This is particularly true of credit ETFs. It is the primary reason credit markets are experiencing such disorderly trading and spreads are moving wider in hyperbolic fashion. A massive liquidity disruption event is underway in credit markets and only decisive official action to supplement bid side liquidity or a slowdown in redemptions (either through a positive confidence shock or by official fiat) will stop its momentum.

As for the horrible Friday close, there are some mitigating factors. The lack of corroboration of the S&P move from other markets could be meaningful. Despite the equity sell-off, the VIX declined by 20% from its high print and continued its decline on Friday hitting its lowest level in a week. QQQ managed to hold above the key 170 support. EEM was actually positive on the day having the prior day made a second touch of the 2015 lows. DXY looks like it may have made a hanging man formation signaling a possible reversal of the bullish trend; if confirmed, this would take some stress off the global financial conditions and would be particularly helpful to EM assets at least in the short term. Certainly, the dollar swap lines provided by the FED are designed to meet the global excess dollar demand and could provide a respite from this current episode of USD strength. JPY continued to weaken, having taken out the 50MAV to the upside on Thursday which may signal abating haven demand. Meanwhile, I have been commenting that gold weakness has been indicative of the broader problem of crowded trades. Gold tested $1450 area support and stabilized Friday indicating that position squaring may have run its course. Separately, as a possible bullish contraindicator, the surge in money market fund inflows indicates that investor perceptions have shifted quickly to that of extreme fear. Meanwhile the AAII bull/bear spread has touched the despair zone, another contraindcator. The AAII reports with a lag, so the next reading will show that we may have reached levels that in the past were associated with near term market bottoms such as in January 2016 and December 2018.   

On the negative side credit markets remained under severe stress, although Thursday and early Friday saw buyers in IG, USHY and EMD. US IG has picked up the pace of new issuance, which would normally be a positive sign, except for the steep IPT discounts that are forcing a cascade of repricing across rating categories. I see credit unwinds continuing for an extended period with the most crowded segments (IG and EMD) likely to suffer the most from outflows. Another negative development was the failure of Ronin announced on Friday. This event revives the specter of the clearinghouse risks of which former economic advisor Gary Cohn had warned. “We get less transparency; we get less liquid assets in the clearinghouse, it does start to resonate to me to be a new systemic problem in the system,” (Reuters quoting Steve Cohn 09/28/17). Ronin's asset liquidation was distributed among clearing members in a sign that the clearinghouse risk mitigation system is still working. However, the fact that one member failed to meet capital requirements is a red flag. It shows that the excessive volatility of the past few weeks will result in more bodies floating to the surface and more asset liquidations. If there is good news from this latest development, it is that this episode is likely to focus the minds of the authorities into taking more forceful actions.

Today there have been some positive news developments. Germany announced a fiscal package of an astounding 10% of GDP. This is an enormous number from the fourth-largest economy in the world. I had mentioned previously that German participation in the global coordination of a fiscal response was vital. It provides air cover for other EU member states to announce more meaningful fiscal reactions of their own. Also, today, Kudlow said that the US fiscal response is shaping up to be closer to $2T, more than double the initially touted number. A globally coordinated monetary and fiscal response is taking shape, which should blunt some of the economic effects of the virus and hopefully provide a much-needed positive confidence shock to markets. 

I expect trading over the next week to be even choppier as traders work from home and risk limits are diminished. The market is liable to experience abrupt moves in either direction in a continuation of this dystopian Disneyland rollercoaster ride.

This market drawdown ranks among the worst and is definitely the speediest:

Source: Bloomberg

2020 COVID19 drawdown and 1929 Analog:

Source: Bloomberg

SPX closed below the Dec 2018 low on Friday. Next major support around 2136:

Source: Bloomberg

However, QQQ tested and held key support at 170:

Source: Bloomberg

EEM actually closed higher in Friday's session having double touched the 2015 reaction low:

Source: Bloomberg

VIX remains elevated, but showed signs of easing this week in a 20% decline:

Source: Bloomberg

DXY candlestick chart detail. Possible reversal pattern. The larger problem of a world structurally short dollars through the build-up of excess dollar liabilities has NOT gone away, but trading respite in the dollar rally may be taking shape:

Source: Bloomberg

In addition to the Money Market Fund asset chart I have shared in my two most recent previous posts, AAII bull/bear spread sentiment may be a contraindicator. Note the data is reported with a lag so the real-time level is likely much further in the "despair" zone:

Source: Bloomberg