“A waterfall cannot be silent, just as the wisdom! When they speak, the voice of power speaks!”
- Mehmet Murat Ildan
Last weekend I wrote that I hoped the recent market volatility would continue. I got my wish. The key to the week was how the market would respond to the Fed’s huge Sunday evening stimulus announcement. Monday’s 12% collapse in the S&P 500 made it clear that the market wasn’t impressed. The Fed has now acted 15 times in the last month. 15! And there’s no way they’re done yet. We’ve been talking for a while about how Fed stimulus wouldn’t work once investor psychology soured. This is what that looks like.
There are a lot of moving parts that are related and impacting one another - the markets, politics, the coronavirus, central bank policy, government stimulus, bailouts, debt, unemployment. I’m tracking it all, but there obviously isn’t time to write about everything happening. I’ll try to focus this piece on a “quick” market update as well as recent trading and near-term plans.
The S&P 500 fell another 15% this past week, putting the total loss from its peak at 32%. That’s a hefty drop, but it’s even more remarkable that it occurred in just 22 trading days. The chart below is updated from last week and shows the damage already done and the potential for more. There’s an old Wall Street saying that the stock market takes the escalator up and the elevator down. The elevator ride is also referred to as a waterfall pattern, hopefully for obvious reasons.
Stocks aren’t the only asset imploding recently. In total, the U.S. bond market is larger than the U.S. stock market, though the latter gets all the press. The bond market can be broken down into subsectors, such as Treasury, corporate, municipal, asset-backed, and mortgage debt. Treasuries, as expected, have benefited (so far) from the panic, especially short-term Treasuries. If you lend money to the U.S. government today for 6 months or less, you’ll be “earning” a negative return. Yep, yields have gone negative in the U.S. That’s what you get when you mix Fed intervention with a rush to safety.
The bond market story is also interesting but in a vastly different way when we move beyond the relative safety of Treasuries. This is where chasing yield comes into play. Recall, many investors rely on yield (interest) from their investments and have been “encouraged” by the Fed to buy riskier securities in the hopes of earning a better yield. Much of this money has flowed into corporate and high-yield (junk) bonds. The longer we went without any major problems in the bond market, the more comfortable investors felt wading into these riskier markets. Making matters worse, hedge funds and other more speculative investors amplified the buying with margin (borrowing) in order to boost returns. Yield chasing and leverage works just fine until the music stops. Well, the pianist just slid off his chair, cracked his head on the keyboard, and is bleeding out.
The chart below shows the performance of the high-yield debt (junk) market. These are lower quality (junk) corporate (junk) bonds – debt of (junk) companies that aren’t in the best financial shape. It’s another waterfall. Over a decade’s worth of capital gains were wiped out in a couple of weeks. In recent years, investors came to believe that they weren’t taking much risk to earn an extra 3-4% over Treasuries. Heck, even former Federal Reserve Chairwoman, Janet (Junk) Yellen, reassured everyone in June of 2017 that there would not be another financial crisis in her lifetime. Why not get a little extra yield here? Well, this chart is why.
It’s a similar story with higher-quality corporate bonds, as shown in the next chart. Many investors thought this was a great place to park some cash for some extra yield. These bond issuers are supposedly strong companies with solid balance sheets. What did they get? Another waterfall, and another decade’s worth of capital gains gone in a couple of weeks.
We stayed away from junk debt altogether. The space has long been riddled with zombie companies whose “tempting” yield wasn’t offering nearly enough juice to compensate for the lurking risks. Many of them relied on refinancing their debt to stay alive, and that works when times are good, cash is cheap, and investors have their heads up their asset-backed bonds. Those days are over.
As for corporates, we avoided ETFs and bond funds and have only owned a handful of high-quality, individual bonds with relatively short maturities. The recent turbulence in the bond market hasn’t impacted us. As bond prices come down, we’ll be looking for opportunities to add some attractive quality yield to our more conservative portfolios – yield that more than compensates us for risk. The panic selling is already creating some interesting opportunities.
A Busy Week
We had another week of fairly active trading for us. As I laid out last weekend, we did continue to pare out of our short positions (bets against the market). We took advantage of the market drop to significantly reduce our put option positions and to start scaling out of our inverse ETFs. We don’t need to be greedy here. The put options served their hedging role well, generating gains of 300-900% in just a couple of months. Basically, our plan has been to scale out of our shorts as the market declines, and that’s exactly what we’ve been doing and will continue to do until the shorts are completely gone. The pace of the market decline will dictate the pace of our selling.
Just as we scale out of the short positions, we’ll be scaling into the bargains that now exist and are being created. We’ve already begun to selectively and very modestly add to some existing and new positions. I have no illusions that these names will rise during a panic, so we’re going to take our time to build them. I have lofty expectations for these securities in time, but in the near-term, I’m sincerely hoping they keep falling and offering even better opportunities to add.
We entered this bear market in pretty good shape. We had a healthy dose of cash, high-quality short-term bonds, and a decent short position on the market. Keep in mind, as well, that most clients also have 401K and other retirement plans that I’ve advised should be parked in money market, stable value, or short-term bond income funds. So, in total, we had a lot of dry powder for the downturn we’ve been expecting. The “risky” portion of our portfolios is concentrated in just a few areas that were already very cheap and possess unique catalysts to drive them significantly higher in the years ahead, regardless of what happens to the overall market. BUT I would expect them to fall with the market as long as the panic and forced deleveraging continues. This is the type of environment we’ve been waiting for to start putting our cash to work, and we’re going to balance our concern over a steeper drop with our eagerness to bargain hunt. We’ll try our best to avoid the danger of the waterfall while appreciating its beauty and power.
Best,
Ken Bell, CFA, CFP, MBA, Budding Aquaphile
03/21/2020
The Market Rubbernecker is associated with Aspera Financial, LLC, an investment management and financial planning firm based in the Cary, Raleigh, and Durham area of North Carolina. This and all Market Rubbernecker missives and musings (written, oral, or mimed) are subject to the disclaimers, disavowals, and hindquarter-coverings found at www.asperafinancial.com/aboutrubbernecker.