11/03/2020 – What happened in previous crashes?

I’ve kept a low profile this week…

Purely because I don’t know what’s going on, so why would I want to tell you anything?

It would be valueless.

Longer term Macrodesiacs know this but for the newer people, it may have seemed odd that I hadn’t given you any information.

That’s because I see risk reduction and not doing anything as a position.

Trading is a game of knowing when to get aggressive and when to just sit out – there’s a lot of similarities with poker to this end.

A quick update though – EURCHF is trading slightly lower (see Saturday’s note) and I’d expect a bit of a grind down as we play deteriorating European sentiment versus the likelihood that the SNB will not be able to weaken the franc adequately enough.

But onto today’s note.

I just want to look at past market dumps and see what the similarities are in terms of their behaviours.

Let’s start by familiarising ourselves with what’s going on right now.

 

The collapse really began at the end of February, and currently we’re about 20% off the high…

Bear market territory.

In 1987, we saw an even bigger drop…
 

And the momentum behind it was even greater.

I think this is probably why those who were active during this period remember it so vividly!

Black Monday was the 19th October…

The market dropped 22.7% in a day.

SH*T.

We’ve not yet seen that, but I’d be more concerned about the slower grind that we’re currently seeing than anything else since it’s showing way more indecision about direction.

Any bounce just keeps getting sold heavily.

Let’s check 2007/08.
 

I think we can clearly see a difference here.

In ’87, there wasn’t really a true reason as to why the crash happened from a fundamental perspective…

It was largely down to algorithmic trading being used in its infancy and a misjudging of the excess kurtosis that algos can lead to…

Excess kurtosis, by the way, is a statistical term describing that a probability, or return distribution, has a kurtosis coefficient that is larger than the coefficient associated with a normal distribution, which is around 3…

OK, in other words, it’s an outlier event that can actually occur more often than recorded in a normal distribution.

The volume of selling that wasn’t accounted for by the algos meant that they essentially locked up and the market just kept dumping, leading to a large sigma move to occur.

In 2008, though, we had an entirely different situation, with fundamentals to back up the decline in market prices.

The credit crunch and subsequent economic meltdown meant the decline in prices was maintained for far longer because recession came about…

If we look at the parallels between what’s occurring now versus what occurred in 2008, we find far more similarity.

Growth rates (ex-US) are pretty stagnated, or indeed are declining.

China, the UK, Europe and even some emerging market economies have been facing poor growth irrespective of the Corona Virus arising or not…

And I think that many of the western economies were going to turn to fiscal spending anyway.

I bring that point up because of the extent to which the UK Treasury have tried to appease the economy Gods with their package released today…

Let’s check out ’08 again to see what the Fed did over this period…
 

Well…

We can see that lowering rates didn’t exactly do anything to avert recession…

And could we argue that QE didn’t exactly jolt the markets to life straight away?

Erm, yes, we can.

Naturally, we have to compare to now.
 
See, what’s truly bad about this is that it is undeniable that the Fed has used their tools to prop markets up…

But these tools when people call bullshit due to actual changing conditions are far from sufficient…

But we’re still left with the same balance sheet size and effects of policies such as ZIRP and QE (the creation of zombie firms, elevated property prices and the liquidity addiction to name a few).

See, central banks are arrogant – they seem to think that they can ease hysteria with policy…

But they can’t.

Fiscally, sure – there could be some good feedback effects.

But we have seen that monetary policy over the last few years does not feed through to the everyday person…

My view is that the policy paths being followed at the moment are there to protect one thing – liquidity and credit markets.

It’s well known that monetary policy has distorted risk to a large extent, but I reckon this is displayed to the fullest extent in credit.

See the article here from the NYT.

One thing the article doesn’t touch on is the issue with cov-lite loans – that is, corporate loans which do not have the adequate protection for the lender (higher chance of default with full risk resting with the lending party)…

Another thing is the issue with the misgrading of ‘perceived’ investment grade credit.

Ratings agencies are again at fault here – echoes of 2008 – since they are the ones that are supposed to judge the creditworthiness of certain corporate bonds…

But they’ve classed many at investment grade, when they should in fact be graded junk!

Check out $HYG, the high-yield ETF.
 

A massive risk for me here lies with pension funds.

They look for yield.

It’s easier to look to credit markets for yield than dividends from equities.

To this extent, they heavily invest in credit.

If ratings agencies have misgraded credit to a large extent (I do not know to which extent they have done this, just that they certainly have), then the end user of pension funds are massively at risk here…

But let’s get one thing straight – let’s not be duped into thinking the Fed can fight a virus.

We’re just waiting for when people get sucked into the zombification nature of low rates…

I am still maintaining the rates will push higher, but now I am changing my timeframe for this since this old virus is a big supply AND demand side shock.

Leave a Comment