Credit Spreads Reach Rare Heights

MONDAY AND TUESDAY’S SESSIONS

Credit spreads speak to economic and financial system confidence. Widening spreads mean market participants are growing increasingly concerned about an economic downturn and increasing odds of bond defaults. We covered spreads Sunday evening and as you might imagine they widened again during Monday’s extremely rare risk-off event. From the Financial Times:


”The S&P 500, the benchmark for the US equity market, lurched lower in the final minutes of trading Monday, eclipsing the worst performance of the pandemic and marking the biggest single-day loss since the crash of October 1987. The tech-heavy Nasdaq Composite had its worst day ever, down 12.3 per cent. The CBOE Volatility index (VIX), the market’s “fear gauge”, jumped to a record high.”

Spreads have reached levels that may help us differentiate between the four cases shown below. The top row of the table shows the extremely rare spike in spreads that took place between February 19 and March 16, 2020. Spreads closed Monday at 8.38, a level reached in only four other periods based on data going back to 1996. Notice how the change in spreads looking back 26 days was significantly higher in the current case, even when compared to high-stress periods in 2000, 2008, 2011, and 2016. The spike in the current case could lead to some unexpected surprises when companies begin to roll over debt at the end of the first quarter.

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How did stocks perform after concern in the credit markets reached similar levels to what was seen during Monday’s risk-off event? It was somewhat of a mixed picture but it is possible that credit markets may help clear that up in the coming days and weeks. The highest reading during the 2020 event is thus far 8.38, which is very close to the highest readings posted in 2011 and 2016. Thus, if credit spreads exceed 9.10 and 8.87, the odds of an imminent low in stocks will diminish and the odds of a more concerning 2000 or 2008-like decline in stocks would increase (based on the historical cases).

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We will continue to track present-day data to try to discern between “imminent low” odds and “a lot more downside in stocks is ahead” odds.

TUESDAY’S SESSION

It is too early to say what Tuesday’s rally in stocks means or does not mean. If it is another one-day bounce, it means little. If the market can continue to rally for a time, it would be easier to remain open to the concept of a bottoming process. From Bloomberg:

“A bear market does not preclude rallies,” said Eleanor Creagh, market strategist at Saxo Capital Markets. “The biggest rallies can be in bear markets -- erratic swings are exacerbated by the present high-volatility regime and strained liquidity conditions. With VIX remaining significantly above the long-term equilibrium, alarm bells are still sounding and traders should be wary of relief rallies.”

We have specific things we are looking for to help identify a potential bottom/bottoming-process and we have several “that is not what we want to see here” items to look for as well. It is best to wake up every day and see how the data evolves.

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More information about the current market can be found in Saturday’s and Monday’s posts.

Walking Forward

1987 AND 2008

We have seen numerous data sets in recent days that align with 2008 and 1987. Another example surfaced after today’s close. The present day VIX is based on a “new methodology”. Since there is more historical data for the original methodology, we used VXO for this comparison.

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The intraday high for VXO was 95.56 during today’s selloff in stocks that featured a drop in the Dow of almost 13%. Drops of that magnitude in one day are rare. As you might imagine, Monday’s VXO readings were rare as well. An intraday VXO reading of 95.56 or higher has only gone into the history books during two other periods (2008 and 1987).

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In the image above, notice how the 2020 rate of change (ROC) in volatility expectations is much more similar in the 1987 case relative to the 2008 case.

HOW DID STOCKS PERFORM WALKING FORWARD?

As shown in the table below, the 1987 case was close to the final low in terms of price, but it took an additional 46 calendar days to register the final low. The 2008 case was quite a bit more painful and featured an additional S&P 500 drop of roughly 25% from the S&P 500 level on October 10, 2008. In the 2008 case, it took 150 additional calendar days to reach the final March 9, 2009 low. In both cases, a sharp 2-3 day countertrend rally occurred with gains ranging between 11% and 15%. Therefore, even if the market has further to fall, we should be prepared for another wild swing to the upside in the days ahead.

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In the 1987 case, the low was successfully retested weeks later. In the 2008 case, the retest of the low failed and was followed by months of additional pain.

THESE CASES SAY WE MUST REMAIN VERY FLEXIBLE

If 2020 turned out to be more similar to the 1987 case, then it would be extremely important for us to respect that major lows are typically made before the fundamental issue is in the rear view mirror. If 2020 turned out to be more similar to the 2008 case, then we must continue to be diligent regarding principal preservation. Both scenarios must be respected walking forward.

At some point in the future, an excellent entry point is going to present itself. Those who remain diligent, focused, and composed will have much greater odds of getting properly aligned with that opportunity relative to those who are frustrated, fearful, and undisciplined. The choice is ours to make.

Fed Launches Largest Set Of Stimulus In History

FED MAKES NUMEROUS MOVES SUNDAY NIGHT:

The Federal Reserve took extremely aggressive action on Sunday evening. From CNBC:

The Federal Reserve, saying “the coronavirus outbreak has harmed communities and disrupted economic activity in many countries, including the United States,” cut interest rates to near-zero on Sunday and launched a massive $700 billion quantitative easing program to shelter the economy from the effects of the virus.

The actions by the Fed appeared to be the largest single day set of moves the bank had ever taken, mirroring in many ways its efforts during the financial crisis that were rolled out over several months. Sunday’s move includes multiple programs, rate cuts and QE, but all in a single day.

Fed actions are powerful forces in markets that should be respected. It would not be surprising if markets responded in a favorable manner. If that is not the case, concerns would increase significantly. The very early read leans concerning, based on how stock futures opened Sunday evening. As always, we will learn something either way in the coming days.

FED REACTING TO CREDIT AND STOCK MARKETS

Credit spreads speak to economic and financial system confidence. Widening spreads mean market participants are growing increasingly concerned about an economic downturn and increasing odds of bond defaults.

We have two forms of concerning evidence: (1) spreads recently reached 7.42% and (2) spreads moved a long way in a very short period of time. Based on credit spread data going back to 1996, there have only been four periods when credit spreads moved from the purple line to the upper blue line (2000, 2008, 2011, and 2016). In terms of respecting what the near-vertical push higher in spreads can mean, notice the near-vertical nature of the move during the financial crisis. The chart below and analysis are based on credit spreads as of Thursday, March 12, 2020.

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Therefore, it might be helpful to know how stocks performed after spreads reached 7.42% in the four previous cases. In the table below, notice stock market performance varied significantly in the recession cases (2000 and 2008) versus the non-recessionary cases (2011 and 2016). In two of the four cases, stocks were close to making a final low, something that is much more realistic given the Fed’s unprecedented moves announced Sunday evening.

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It is also relevant to note how serious the walk forward look was in the two cases that featured recessions (2000 and 2008 cases in table above). From Bloomberg:

The velocity of the U.S. move makes it incomparable to previous routs except the great financial crisis of 2008.

“This is happening at light speed this time, and it’s mostly because of credit spreads widening so much, it’s not about bank liquidity,” said Ira Jersey, chief U.S. interest rates strategist at Bloomberg Intelligence. “We’re pricing in a global recession of some magnitude.”

“The speed of the deterioration is important because of the shock effect, and because it makes forecasting harder,” said Torsten Slok, chief economist at Deutsche Bank Ag in New York. “We’re looking for whether people will be laid off, and if companies can roll over loans.”

THERE WILL BE ANOTHER SIDE AT SOME POINT

While we should all respect the seriousness of this virus, it is also important to understand that things will improve at some point in the future. This week’s video takes a look at the current situation and provides some historical context, allowing us to respect present-day risks without slipping into a state of long-term despair.

MAXIMUM FLEXIBILITY

Given the rare oversold state of the markets in recent days and unprecedented Fed action on Sunday evening, we will head into the new week with an open mind about all outcomes. In terms of the markets, we are not making any assumptions about anything (good, bad, or indifferent).

Our large cash position speaks to the uncertainty associated with an unprecedented deterioration in market-related data. Thus far, the market has only been able to muster a few one-day rallies. Until the market can prove something on a sustained basis, we will continue to walk forward with a defensive posture.