Corona Virus Chronicles (VII) - Whiplash
It is difficult to build a case for being in the markets at this time when you are a conservative investor.
The chart of the ten year view of Volatility, as measured by The Chicago Board of Options Exchange (CBOE) reached these peak levels; on 20th November 2008 to be precise. However, it also had been elevated throughout October, peaking in that month at 80 on the 27th October. What does this tell us? If nothing else, that volatility can remain elevated for quite a long period of time and that this level can still, yet, be breached. Volatility spikes when markets are within a negative cycle. It makes sense to say that this current peak marks a new high for this cycle, but we cannot say that peak volatility is in the record book for this current time.
Conservative investors call the markets “uninvestible” when Volatility moves above 30/31. The index first moved above 30 at the end of February. The after-peak reaction to this type of market, is one of retracement and as this started being written, stock market futures were forecasting a positive trend in bourses for the opening in Europe, as it was being finished bourses were lower by a few percentage points. A positive opening would prompt a fall in Volatility, but the subsequent falls would increase the level of volatility and hence we have these dramatic, whip-sawing markets. It is difficult to build a case for being in the markets at this time when you are a conservative investor.
These comments from JPM are worth taking on board:
JPMorgan Chase & Co: “In order for a more lasting market rally, we believe that we need to see either an exceptional policy response, which has not happened yet, or more directly, we would need to become comfortable that the peaking out in the virus outbreak is at hand. This still seems to be quite far away, and things could get a lot worse before they get better.”JPM (cont’d)…On stocks, “we note that markets lost more than half of their initial value during the last two recessions, versus current 20%. In addition, the last three recessions saw P/E multiples of 10.1x, 13.8x, and 10.2x at the low, while current P/E stands at 15.2x, and 14.5x at the recent trough on 12 March. There could be room for more de-rating from here.”
They are suggesting that even though the US or other economies have yet to publish growth numbers covering the start of “Epidemia” and despite the market moves, there could still be more follow through to the downside, to reach the valuation points seen in times of full recessions. Recession is classified as “a significant decline in economic activity spread across the economy, lasting more than two quarters which is 6 months” – significant means negative GDP.
JPM’s “Price Earnings” point is worth looking at. A fall in the PE ratio of an index such as the S&P 500 to a PE ratio of 10x, if recession proves to be the case, indicates a significant move lower from here. Currently the collective EPS statistic for the S&P Index stands at 152. The Price Earnings ratio is calculated simply as “Price” (the index level) divided by “Earnings Per Share”. A PE of 10x, the historically observed recession period ratio, on earnings of 152 equates to an index of 1520. This simple analysis implies a decline in the S&P of some 35% from here. Whether this happens is speculation, of course. However, these are extraordinary times and now we need to ask what would now stop economies from recession? We already know the cause of recession and it is awful on so many levels…
Either way we should look to the lead of credit markets.
Credit, or bond markets have effectively shut down. There has been no recent new issuance. This point in of itself is a newsworthy situation, where normally we would see several Billions of Euro and USD issuance every day. Corporate bond markets are being pushed to extremes. Spreads are moving higher all the time (yields higher = prices lower) and this is a major concern. Investors, trying to sell this market, are implying that the probability of companies heading into default is increasing - and increasing rapidly. The cascading domino effect of market distress starts in low grade (BB/B) corporate bonds. Oil and Travel sectors, for instance, without Government intervention, will default. Investors are stepping back from lending via bonds, denying credit supply in general and increasing pressure on any company with a need for credit renewal or extension. If the distress of the sub-investment grade market continues, it will start to impact the BBB dominated investment grade market, where spreads are already very high. The continuance of high credit spreads will, definitively, cause waves of corporate distress. All of this is before consideration about the ability to efficiently deal in bond markets, where we can be absolutely certain that there is severe curtailment.
As the credit market unravels, it is only understandable that equity markets de-rate to take into account the risk of increasing levels of corporate defaults.
We continue to be exceptionally cautious.
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About the Author
Peter Smart, Head of Investments
Peter has been involved in investment markets since 1985, working within the private client areas of two global banks and for 22 years as the fixed income specialist for the UK Wealth manager, Brewin Dolphin. More recently Peter formed part of the investment team at bridport in Jersey specialising in the provision of specialist, income focussed portfolio’s.