Human beings always need to find a narrative to explain a phenomenon. It is a basic instinct, to understand, to rationalize, allowing us then to accept. The media and press commentators, sell-side analysts and traders all have been releasing a barrage of anecdotes to explain the recent market selloff. The S&P 500 rallied 18% since October 2019, but it has given up nearly 7% in just three days.
If one were to pull up the daily or the weekly chart, it would make for quite a nauseating read. The astonishing observation over the past year was that earnings in the S&P 500 grew just 2.8%, yet the index climbed 15% (ignoring the December 2018 debacle, as that was quickly reversed). The P/E multiple went from 16.5x to 20.7x, around 25% growth. So 2019 was all about multiple expansion, even if earnings did not keep up pace with the market moves.
Similarly, in 2018, earnings grew 22%, yet the P/E multiple went from 21.4x down to 16.5x. What does that tell you about the market? A child's answer would be to say earnings do not matter, which, to be fair, would be entirely accurate in this case. What does matter then? The U.S. Fed's Quantitative Easing (oops sorry not-QE QE).
Sometimes the simplest of answers is perhaps the best one. The growth in earnings and asset prices have all been exacerbated by the Fed and various central banks around the world printing money to no end to keep the growth engine moving along. The problem is that the engine is so old and heavy that it takes a lot more money to produce the same rate of growth, which makes it harder. Central banks have not learned their lessons from the past -- and they keep doing the same thing.
The ECB is clear case in point. After decades of quantitative easing (at least they admit it, I give them that), Europe is still in the doldrums and so are their markets. In 2018, we blamed the Trade Wars for the collapse in markets and in 2020 the Coronavirus. These were all exogenous catalysts -- the straw that tipped the camel's back.
In reality, what caused markets to fall and rise over the last few years has been U.S. central bank policy. In Spring of 2018, the Fed started quantitative tightening, to ease the world of the excess reserves in the system, a brave and valiant move. Only to then do a 180 degree turn when markets collapsed in December 2018, as they realized the system cannot get rid of any excess reserves. The Fed has freaked out at every dollar rally and market downturn and has changed its policy tune to its song.
The same happened in September 2019, when the repo market called its bluff on the Fed. How did the Fed react? Let's grow the balance sheet exponentially by $500 billion+ to kill this problem. Lo and behold, markets rallied all the way until January this year, as the Fed was committed to daily repo operations and Treasury bill buying.
But something changed last week. The Fed, during its January FOMC minutes, suggested a "tapering" or "phasing out" of its not-QE QE operations prior to April.
Boom! That was the signal for the herd-following, fundamental-defying traders to take their money and run. We all could feel the market was getting way ahead of itself over the last few months, but were too greedy to be part of it as long as the Fed was playing ball. Call it what you want, but it was not fundamental. Analysts throw P/E, EV/EBITDA at me in January -- where does that get you? And if these stocks looked cheap back then, they sure as heck look cheap now, down 15%. But of course, we don't hear the same "analysis" now. It is all about timing.
The Bond market refuses to listen to its Equity brethren, purely because it is and has always been way smarter than the Equity crew. Equities are the most impressionable asset class, always following and taking leads from other asset classes forced by tons of strategies pushing and pulling it.
The Bond market has spoken, as yields have now crashed to lows made back in 2016, with the 10-year trading at 1.32% and 30-year at 1.83%. They are screaming deflation. Poor Fed Powell thought he was done with easing and could sit back, but now looks like he is victim to the Bond market and may have to cut interest rates by at least 25-50 basis points. The world cannot live with higher interest rates or no monetary accommodation, or a stronger dollar. It is just the way things are and the Fed knows it.
We have too much debt in the financial system, and that can never be reduced, as more and more is needed to provide the growth the world so desperately needs. Until one day the bubble bursts. I'm not sure we are there yet, it all depends how fast the system cracks as all asset classes and derivatives are linked. More importantly, how fast the U.S. central bank reacts.
The Coronavirus outbreak has highlighted some severe flaws in the system. It is a real and present threat to demand slowdown and global economic growth. However, just like SARS, MERS, or other influenza-related slowdowns, it too shall pass eventually. But right now, we seem to be in the eye of the storm as containment is still not known as cases start to appear in other parts of the world outside China.
Cases in China seem to have slowed down, even though the death toll is rising. What was different this time is that China came to a screeching halt and shut down businesses and factories; it shut down production. That sees an immediate impact to anything that China consumes, mostly Commodities like Oil and Copper. The real impact may be a lot less, but the market trades as though demand is going down to 0. Therein lies the opportunity, once the dust settles. It does not help when U.S. economic data starts showing weakness as well, when we saw that the Richmond Fed's manufacturing survey fell to -2 from expectations of +10, with new order volume slowing to -10 and capacity utilization fell to 2 vs. 14 the prior month.
For now, there are the leveraged CTAs and machine algorithms that are seeing red warning signals on their screens. The market has broken its key 100-day moving average in the major indices with the Russell 2000 having broken its 20- day. This could either be a blip in the markets or a 2000-style correction. It is unclear now.
Only two things can save the market, the Fed cutting rates aggressively or the virus being contained. The latter is far from clear, as other nations are dealing with the impact. It is best to sit in cash on the sidelines than catch a falling knife. Fundamentals and value go out the door at times of uncertainty, especially when the one thing that supported the market all along, the Fed's moolah, is on hold for now.