Monday, March 9, 2020

Thoughts on market crashes

Back in October of 1987 I was one year into my job at Leland O'Brien Rubinstein (LOR), the firm that was later accused of having caused the biggest stock market crash in modern times (that's a story for another day). Sunday night, October 18th, I remember thinking "tomorrow is going to be very ugly." And indeed it was, as the stock market went on to lose more than one-third of its value in the span of just two months. Last night I thought the same, and this morning the market opened almost 20% below its all-time high registered a bit less than 3 weeks ago.

The Crash of October 1987 shocked the world, but—to me—the most surprising result of all the angst and turmoil was that it didn't precipitate a recession. Indeed, real GDP growth in Q4/87 was a rather spectacular 7%. There's a lot of fear behind the current selloff, but there is also something tangible to worry about, and that is of course the potential of a teeny-tiny virus to upset—and possible even to derail—the global economy. Back in 1987 it seemed inconceivable that we would avoid a recession, and it seems that way now too.

Today's Vix index didn't exist in 1987, but I recall that calculations of implied stock market volatility at its peak were in the neighborhood of 100+. Earlier this morning the Vix shot up to 62, but it's still lower than the all-time high of 90, which was registered in October 2008. We're not at record levels of panic yet, but we're pretty close, and so far the number of American victims of the virus is practically de minimis, but sure to soar.

Scientists are working furiously on vaccines and therapeutics. Markets are consumed with risk sharing—those willing to bear downside risk are being compensated handsomely, while those with low risk tolerances are locking in huge losses. Liquid markets act as shock absorbers for the physical economy, and there is no sign to date that liquidity is drying up. Central banks are supplying needed liquidity, and another round of Quantitative Easing seems like a no-brainer. Fiscal policy, however, is a clumsy tool at times like this; better to let market pricing solve problems by directing resources to their highest and best use.

How all of this sorts in the next few days and weeks is anybody's guess. But it's a sure bet that we are nowhere near the end of the world as we know it.

Here are some relevant charts with prices as of 12:30 pm Eastern time:

Chart #1

The current decline in stock prices seems tame compared to other periods of panic.

Chart #2

Short-term interest rates have collapsed to near-zero. The demand for safe assets is intense.

Chart #3

Credit spreads have jumped, similar to what happened when oil prices collapsed in 2015-16. The market is concerned that sharply lower oil prices will bankrupt many oil producers.

Chart #4

Systemic risk is still relatively low, especially in the U.S. market, and liquidity is still abundant. Markets are not freezing up as they did in late-2008. That is a very good sign.

Chart #5

The dollar today is pretty close to its average over the past 5 years, and nowhere near being dangerously weak nor worrisomely strong. Oil prices have suddenly become cheap again. Good for consumers, bad for producers. In any event, we've lived through this sort of thing before and the world didn't end.

Chart #6

The Vix jumped to 62 at the open, and is currently trading at 53 or so. Options on stocks are extremely expensive for those who want to minimize risk, and extremely attractive for those willing to bear risk. This is the proper function of markets—using prices to shift risk to those who are willing to bear it.


Larry said...
This comment has been removed by the author.
Scott Hammond said...

sell puts on everything

The Cliff Claven of Finance said...

The modern mainstream media hypes everything that could make President Trump look bad:
Russia Collusion
Ukraine Extortion

You'd think it was the bubonic plague.

I wish the mainstream media spent a lot more time showing Joe Biden's gaffes, to entertain us.

Influenza kills 300,000 to 600,000 people in the world each year.

COVID-19 seems minor, so far, compared with all flu deaths.

The stock market S&P500 was at record valuation levels based on Price to Sales Ratio and Market Cap as a Percentage of US GDP -- two valuation indicators that work very well for ten year stock return predictions.

A correction was overdue, maybe even a bear market.

The P/E Ratio is not even close to being a good long term indicator, except for the 10 year Shiller version

Also the stock market does not climb a "wall of worry".

Stock prices march up a ladder of growing confidence, and when investor confidence peaks, stock prices fall.

1987 was not a useful example -- I recall the market was up about 30%, crashed, and then finished the year about where it started. I had about 30% cash when the crash happened, and invested all the cash in the next week.That crash was unrelated to any business slowdown. The coronavirus IS causing a business slowdown -- it might last only a month, or maybe many months -- no one knows -- and that mystery hurts investor confidence.

Johnny Bee Dawg said...

I’m not sure this is all about virus. At all.

The price war in oil is brutalizing sectors and dislodging trades in the Treasury markets.
Who will default?? Is it just Putin ginning up nationalism?
Half-point spreads between bid and ask in Treasuries. Unreal.
No bids this am for the 30 year futures.
Anecdotal news of shrinking credit lines

The SPLV-TLT combo is positive today, but TLT still yields 1.7% vs underlying assets at 1% yields.
To me, that massive discount seems like total complacency in the retail markets.
We have had INFLOWS, not outflows. This seems wrong if we are to bottom soon.
Fed is way behind. Would like to see Fed Funds at zero....get the curve right.

JDonley said...

thanks for taking time to send a pep talk. i imagine W. Buffett has backed the truck up today.

put some cash to work today with AMLP yielding 16%. surely not all of the pipeline companies in this partnership will quit paying dividends. in a month i'll be kicking my ass for buying, or for being too timid.

Charlie said...

On the science side here is a good twitter feed to follow: Bedford is genomics faculty at UW and Fred Hutch.

Also, here is a basic math refresher on exponential growth and logistic curves: Note the point made in the last minute: if we reduced transmission per encounter by 2/3, we could reduce expected worldwide cases in 2 months from ~100,000,000 to ~400,000. Same effect if we reduced encounters by 2/3s, or the product of the two. Caveats: simplified model, estimated parameters, cases in the video are really reported cases, etc. But the basic shape of the result will hold UNLESS we are lucky (e.g., strong seasonal effect).

Some of the above is being communicated at Pence's briefings. Fauci is careful to praise Trump at each briefing before contradicting him with real information. I'm hopefully optimistic that Trump is too afraid to fire his top scientists while things are hot.

Scott Grannis said...

A thought: never before, at least in modern times, has the world been so keenly aware of a pandemic threat and at such an early stage. Many people, including myself and my extended family, are taking precautions we never dreamed of before, such as canceling major trips. Several countries are taking measures that would have been though beyond extreme. With any luck, this whole thing could prove to be over-hyped (as has happened with a lot of supposedly imminent disasters).

Charlie said...

The irony here is that:

IF scientists are successful in communicating reality about reducing transmission and encounters, then it won't be a disaster at all (see my post above) and scientists will take a big hit for "over-hyping" the situation.

IF, however, others are more successful in communicating a lot of nonsense, then it will indeed be disaster.

I hope for the former.

Johnny Bee Dawg said...

Charlie: What info did Dr. Fauci contradict?

Charlie said...

Here are some points of misinformation that we have known, for more than a month, to be false. The message from the government is, well, mixed. Often you hear the exact point of misinformation followed (sometimes in the same briefing) by a correction from an expert. Sometimes the contradiction is softened with a technical sounding qualifier (e.g., "deployable" vaccine), but this only muddles the correct information. (What the heck is a non-deployable vaccine? My wife is a virologist and has never heard of such a thing.)

1. There will be a vaccine "soon" or "in months" or "experts say a year at the outside". This is false. Fauci and other experts continue to tell us a year to 18 months.
2. It is like seasonal flu. This is false. It is in fact more lethal than seasonal flu, more transmissible (absent any changes in human behavior), there is no existing herd immunity from previous exposure and/or vaccination, and no data (yet) telling us whether it will or won't be seasonal.
3. A ton of magical thinking along the lines: "I think that whole situation will start working out". Containment is "close to airtight". Etc.

@JBD, google for video examples. The liberal media is damn near wetting-its-pants happy to provide examples. They are real.

Sure, 100,000s of dead in US (assuming no one does anything to slow the spread) isn't the end of the world. My stock portfolio will be fine (that's my worthless opinion). Heck, it could be a great time to shop for a retirement home.

However, a more preferable outcome would be clear communication from the government. A sharp and temporary change in human behavior. The virus fizzles and is kept in check until it simply goes extinct (regionally) and then there is a vaccine. This is a possible outcome.

The current situation is that companies and families know they have to figure it out for themselves (as demonstrated in Scott's post above). This is not ideal.

Unknown said...

Careful use of licorice root and/or hemp root can help protect one against the novel Coronavirus.
Market has been long due for a correction, after being politically propped/trumped up for around 2 years now. Market will reach a long-term bottom in its 18-year cycle around November 2027. It reached its long-term top in August of 2018. The rest since then has been a propped-up bubble which is finally bursting. Fair value on the Dow should be around 21,500 at this point in its long-term downtrend. If it gets as bad as 2008,the 2027 low on the Dow could hit 13,000.

Unknown said...

The fact that rates are so near zero combined with the fact that the fed is pumping billions into the market on a monthly basis does not say to me "this is a healthy economy" infact it suggests quite the opposite, and both of those factors were at play before the corona virus. Couple that with the fact that the virus is taking a major toll on the entire worlds economy's and I'm willing to bet you get recession in the not to distant future. I'm in Washington State where the virus is spreading rapidly, we havent seen the end of its destruction on the economy. I will agree with the author that this is probably not the end of the world as we know it, just the beginning of a recession we will one day get past.

Unknown said...

Man I totally agree with you about the media hyping anything that could make trump look bad, he could save 1000 babies from a burning building and they wouldent mention it. I like your comment. Although I'm in Washington State where the virus is the worst in the USA and I feel the media is really down playing this virus, way more people have it here than are reported, I personally know people who are afraid they have it and are showing symptoms but they can't get tested, I believe far more people have it than are reported and I believe it will cause more economic damage than is being reported. But I also agree that this will just be a recession that we will get over, not the end of the world as we know it

Unknown said...

We're already @ 1.25% interest, u think cutting to zero will fix this? We have been near zero for over a decade, the fed it now pumping QE 4 to the sum of billions a month into the markets, changing theire rules and raising theire ceilings ever higher, that dosent scream "what a great and healthy market). Top that with the absolutely massive economic damage of multiple countries being effectively closed for business, supply chains at a halt, and now the number of infected people in the U.s. ever rising. cutting to zero and "getting the yeild curve right" aint gonna fix what ails us... The already damaged and highly manipulated highly overvalued market was the dry grass that the coronavirus spark landed in

Unknown said...

How did fauci contradict trump?

Unknown said...

Hahahahahaha you are very funny, you know when the tops and bottoms of the market are going to happen? You must be the worlds most wealthy person then, hell since you know all the tops/bottoms and know the proper and never changing "cycle" I suppose your getting calls from Goldman sachs and jp Morgan all day every day begging for you to work for them!

Johnny Bee Dawg said...

Charlie. Most of that is in your imagination.
At least I now understand where you are coming from.

Benjamin Cole said...

Great blogging. Wait for one more shoe to drop, and then I think we see a buying opportunity.

I am deeply disappointed that the Trump Administration's good idea, that is a payroll tax holiday until the end of the year, has not been well received by Congress.

I guess the Donks are against Trump's tax cuts cuz they want him to lose in November, and the GOP prefers tax cuts that target the wealthy and high-income party-backers.

The national interest? That's an idea for chumps.

minnesota nice said...

Thank you for your years of valuable commentary.
On a side note - I, and others, would love to hear the "story for another day".
You should document your 1987 experience.

Adam said...

Wallop caused recession not likely. Fisher says that total damage for US GDP is max. 1 trn USD. This is 1/4 of the yearly GDP growth.

Charlie said...

Link is an infographic showing different death rates from Spanish flu in Philadelphia versus St. Louis as a consequence of social distancing.

Can we take these curves as proxy for economic impact? If so, then clear communication from the government and media outlets would go a long way in reducing eventual economic impact.

randy said...

Benjamin - exactly right. Just disgusting.

Scott Grannis said...

Adam, $1 trillion is roughly 4.5% of US GDP (~$22 trillion). Before the virus, nominal GDP growth this year was projected to be almost $1 trillion. So if the virus erases $1 trillion from this year's GDP, we will almost surely have a recession.

That's the bad news. The good news, possibly, is that the market today seems to be pricing in the likelihood of a recession.

randy said...

Also... Biden trounced Sanders in yesterdays contests. According to 538 Biden is now virtually assured the nomination. Since the market is tanking again, I suppose we have to discount the idea that the market crash was in a large part driven by fear of Sanders.

steve said...

Randy, that opinion is, with all due respect, nonsense. Who knows how much lower the market would be if CRAZY Bernie was leading?

Scott Grannis said...

One could argue that what is driving the market down is not the fear that Bernie might become president, but rather the fear that a virus-weakened economy might doom Trump's chances of re-election. Any and all of the many Democrats who entered the race who might win in November would pose an existential threat to the U.S. economy, because they all favor higher taxes, more regulation, and a Green agenda that could smother economic growth for decades.

Personally, I think the current market weakness is driven primarily by fear of the economic unknown; just how bad is this global pandemic going to be for growth? Nobody knows, and most of the speculation is dire.

I'm holding out hope that the public's rapid response to the virus threat may end up short-circuiting its advance in relatively short order. And I also think it's possible that science can find a solution to this problem sooner than most "experts" seem to think.

randy said...
This comment has been removed by the author.
randy said...

In a strange way, it's a shame that the virus added such a variable to the election. We will now never know if (at this time) the Democrats could actually nominate a socialist that wants to tear down the most successful country in history, or if it was mostly media savvy activists making noise and the Democrat voters would have rejected Bernie outright.

Further... if he had been nominated, would he have been trounced by Trump, and maybe even cause the Democrats to lose the house. And would that have been a cathartic event that purges the idealist appeal of socialism for another few decades. Forcing Democrat leadership to return to reality on other positions.

I take that back... I'm afraid to know the answer and glad we don't have to risk it. (Obviously CA will back Bernie. That's scary.)