March 19, 2020

Buy or sell? The current stock market conundrum

The complexity of the financial system is exacerbating uncertainty, and so governments and their respective central banks are compensating by pledging significant support: in effect they are guessing what the market’s guestimate of the potential damage is. 

By luck or judgement, earlier articles I published pointed towards this market crash …

And we discussed why this crisis had the potential to be quite severe ..

Today, we explore the light at the end of the tunnel, whilst still having an abundance of caution. It would be useful to read the to prior articles above, to understand the framework of arguments made here.

We had announcements in a number of countries yesterday, pointing to the potential stimulus measures. PM Boris Johnson’s reference to their being ‘no ideological boundaries’ was perhaps most indicative of the stimulus zeitgeist. 

Be it the French pledge to ensure there are ‘zero bankruptcy’ to a Republican US President pledging ‘helicopter money’ (or cheques directly to citizens), governments are acting far more quickly than in 2008 and with far more extraordinary measures. However, the UK’s robust Tory majority contrasted with the the deep split that still exists in US politics. Chancellor Sunak was able to commit to a package that was as much as 15% of UK GDP, the legislation having been passed that means he can spend far more. By contrast to the UK and the EU, the US commitment of under (at $850 bn of a $19.3 trn GDP) 5% of GDP appeared relatively meagre. 

Why do we need so much money?

Policy makers have learned from the 2008 crisis, that more than the specific losses of a particular sector, the bigger risk to the system is the interaction between banks, investors and the real economy. The Fed has acted early to provide liquidity, against bonds and now stocks too.

The complexity of the financial system is exacerbating uncertainty, and so governments and their respective central banks are compensating by pledging significant support: in effect they are guessing what the market’s guestimate of the potential damage is. 

Why isn’t the market moving up? 

The rudimentary answer to that question is always, ‘supply and demand’, however attributing reason to investor sentiment requires conjecture. 

The primary reason seems to be uncertainty. The effects of Covid-19 remain uncertain. It is becoming clearer that depressed high streets could remain that way for more than a few weeks or even months, and of course history tells us that pandemics often come in two waves, with the second being more virulent. 

However, uncertainty relating to the economy is likely to be the most important issue. Whilst ‘helicopter money’ (the government sending cheques directly to citizens) is reassuring: a policy once only the ‘leftist’ Mr Sanders would have mooted, is now US government policy which is evidence of crossing an important ideological rubicon (and something rejected by Director of Trump’s National Economic Council, Mr Larry Kudlow only weeks ago).

As Treasury Secretary, Steve Mnuchin, explained to Republican Senators, a lack of action now could lead to 20% unemployment and a ‘depression’. To be contemplating a ‘depression’ only weeks after the market was pricing in a healthy economy, with record unemployment, is a dramatic shift in fundamentals.

And so within those two boundaries (a heady economy and depression) we have ‘reality’, and where it settles will depend on a number of things. It is unrealistic to expect the market to return to the heady heights of February, given the economic damage being anticipated. In reality, regardless of ‘helicopter money’, it is hard to see the average person spending as normal, whilst receiving charity from the state, and so even the most generous fiscal package can’t be a substitute for the confidence of a robust economy. However, the establishment is acting robustly, unlike failures in the Great Depression of the 1930s, when asset prices fell 90%. 

So we aren’t going back to the glory days soon, but neither should there be a depression. More likely we will settle somewhere in the middle dependent on policy action. The market’s understanding of the potential longevity of Covid-19 is improving (and may soon price it in fully), but concern is turning first to the real economy and secondly to the unknown risks lurking within a leveraged and complacent financial system.

Calling the bottom?

Don’t catch a falling knife…

… is advice often given to young traders, though with the advent of Quantitative Easing perhaps it should be changed. Risk indicators (rallying dollar, vix, etc) and price action indicate there is a lot of pain out there, and market participants are likely liquidating positions in distress. Retail investors were assured this was just the ‘flu’ and many bought the market at 20% down and may now be contemplating exiting.

More concerning were reports of ‘negotiations’ with the Senate (where power almost equally shared between Republicans and Democrats) and in particular resistance from the ‘deficit hawks’. In 2008 it was political inaction that preceded the devastating month of October 2008. The markets don’t seem to think the measures announced are sufficient, and ‘deficit hawks’ may think they are going too far. Any signs of a political impasse this time round could prompt a more severe bout of selling.

There are many calls to ‘buy assets you will hold for five years’, which make some sense, as calling the bottom (like market timing) isn’t possible, but often in more severe crisis you have time at the end of the sell off. Market panics are exhausting, and judging from positioning, a great many investors will be licking their wounds for a few months.

Light at the end of the tunnel

That said, the speed and scope of policy response (from ‘helicopter money’ to Fed liquidity for stocks) is impressive. Whilst the markets may want more, and we may need to see the return of the ‘Troubled Asset Relief Programme’ (TARP) to buy bad assets from banks, governments are moving much more quickly than they did in 2008. 

Money will be printed, a depression will be avoided. How far asset prices fall in the interim is the trillion dollar question.

Photo by Chris Liverani on Unsplash

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