Models have a strange way of spitting all the right numbers at you if you put in a certain set of constraints, giving you a false sense of illusion that "nothing can possibly go wrong". A model is after all just a smart mechanism to analyse a sample of data, data being the key here! The 1970's experienced some of the highest inflation numbers in history. Since 1980, after U.S. inflation reached a high of 12.5%, it has been falling gradually ever since. But the average investor in the market these days has not been around long enough to know what inflation is, other than just reading about. They have always felt safe with the knowledge of the "Fed put" being firmly in place, hence the buy-the-dip mentality.
Investors and institutions have held onto this belief in an almost religious sense, a commandment set in stone by a higher being. In the deflationary world of the past 40 years of data, so to speak, bonds and equities have been inversely correlated, hence giving a perfect hedge in various economic cycles. The behavior of these two asset classes is what formed the infamous 60-40 Risk Parity strategic risk allocation that today is the cornerstone of every single financial advisor for institutions and retail. The model suggested a delicate balance geared 60% towards equities and 40% towards bonds. It proved to be the perfect hedge because if rates went down, bonds would move higher to compensate for the equity loss, or vice versa. This strategy worked beautifully, until today. The model firmly broke down this month as investors are getting crushed on both their equity and bond longs. There is no diversification! So, what changed?
Based on the existing Risk Parity model, the current liquidation, the ultimate dollar margin call, is forcing asset managers all over the world to sell everything without discretion, so that they can raise cash, and fast. Back in February 2018 when the short volatility - Volmageddon - blew up as it wiped out the entire short volatility (VXN) structure to zero, it caused a ripple in this 60-40 portfolio, but what we are witnessing today is essentially an 8-sigma event! In layman's terms, a mathematically impossible or a 0.0001% chance of this tail event happening, as long as the data set used is the only sample we have. Did we ever put in data prior to 1970s is anyone one's guess. Institutions piled into this trade in spades as they never foresaw it breaking down. There are many reasons why it is breaking down and that we may be entering a new paradigm shift in asset allocation altogether. As the Everything Bubble is bursting after 11 years of a straight record long bullish run facilitated by the Fed printing endless amounts, the monster got too big to feed, that finally the Coronavirus was the pin causing massive collapse across all asset classes.
Previously the 60-40 equity/bonds relation worked in a deflationary environment, but in this new world where the Fed and central banks around the globe are printing money like there's no tomorrow, we will enter a hyper inflationary world at some point. In that environment bonds and equities will move together in the same direction, and the 60-40 model will not work anymore. That remains to be seen, but 36 million retail accounts in the U.S. have all been advised to be in this old Risk Parity model as there was no "risk" given the performance of the past 11 years. Wake up call?
The S&P 500 has fallen 30% in less than one month, and we have officially wiped out the returns of the last three years in this time. Investors are wondering if this is low enough or whether it can go even lower? In 2008 markets fell close to 50% before we found a bottom. It is not the fall that has shocked us, but the pace at which it has fallen. As the U.S. goes into lockdown now, we can assume Q2 will start to see the brunt of the extreme slowdown and possibly even print -5% GDP, according to Goldman Sachs. We have entered recession now. A simple back of the envelope calculation can help put it in perspective. Earnings per share for the S&P 500 in 2019 was $135. Assuming earnings fall by 20% - possible during times of recession - the new earnings per share can be $108/share. Allowing a generous multiple of 15x even, would put the S&P 500 at 1600 ~ another 30% fall. I am not suggesting that we fall that much more. Just suggesting that depending on how severe the economic slowdown is and how long it takes to contain this could carry the weakness out till the end of Q2. Once things stabilize, it will still take time to return to some form of normalcy, certainly not the same throttle prior to the crisis.
According to Nomura's Charlie McElligott's recent note, Active Manager Exposure to U.S. Equities printed lows last made in 2011 and 2014. That is how much has been sold aggressively. The selling has been exacerbated by liquidation in Corporate Bonds, Investment Grade Bonds, Treasuries, Gold, Oil together, with a rush for the dollar. The Fed has this week bought about $307 billion in Treasuries and Mortgage Backed Bonds vs. $162 billion bought in March 2009 during the Lehman crisis. In one week they have injected more liquidity than in the entire QE2. Just today the Fed will be buying about $100 billion alone. The Fed's balance sheet as of last week stood at $4.7 trillion, vs. $3.7 trillion back in September when they first started the non-QE QE, but at least now it's official. That is a 50%+ increase in six months. Still the index is struggling to make meaningful headway. One can just imagine the amount of selling that is soaking up all that liquidity.
Today is an important day as it is Quadruple Witching Expiry week, whereby all the Index and Equity options expire. March is a quarter end and so a lot of open interest will expire. This has been an important factor and has exacerbated the volatility this week causing +-10% moves as dealers have had to hedge long or short into market rallies and falls... negative gamma. Next week it is predicted that volatility will fall as there will be less need of hedging by banks and dealers. Month end pension rebalancing will see some equity inflows vs. bond outflows given how wide that spread is currently, in the order of $120 billion-$200 billion which will be supportive for equities short term.
The economic slowdown together with the relentless dollar short cover does not seem like it is over as it will take time for deleveraging to stabilize. But there can be nasty periods of rallies even in a bear market. From today, now, all technical momentum and strategic indicators are super stretched to the downside as we are in a maximum bearish mode. Following all this negative gamma expiring, perhaps selling has been exhausted in the short-term?