I Have Never Been More Uncertain
Up until early April the stock market (specifically US equities) was making sense. A global pandemic and oil war created mass uncertainly which drove a massive selloff as investors headed towards safer waters. However in recent weeks things have absolutely gotten out of hand. What started as a rally off of a massive drop quickly morphed into a beast that makes no sense.
Record shattering unemployment? Stocks go up. Rising COVID-19 death and case counts? Stocks go up. Multiple industries facing unprecedented levels of economic pressure? Stocks go up. Earnings slashed 60%? Stocks. Go. Up. The list goes on and on.
Thanks to Fed’s pledge to essentially provide QE Infinity to the economy, asset prices have effectively decoupled from not only fundamentals but also broader macro outlooks. The dangers here are extreme and essentially breaks the future down into two possibilities:
- Using trillions of dollars the Fed is able to backstop this event and the economy is back on track by Q4 2020. Stocks rip to new highs like we’ve never seen before. Somehow we manage to dodge inflation and a virus resurgence.
- The Fed utilizes QE infinity sending it’s balance sheet soaring to $10T+ but its not enough. Economic activity slows, unemployment spikes, GDP recedes, and the high of cheap debt US companies have been experiencing for the last decade wears off. Earnings multiples begin to recede to fairer levels and stocks crumble.
So which way do you bet? Well, let’s look at the data:
Liquidity
I’m a big believer that liquidity drives markets. The biggest price swings will be seen in markets where spreads between bids and asks widen and transactions slow. Another way of saying this is that when people are uncertain about a certain price level the price level will rise or fall until that certainty is regained.
Liquidity is hard to measure but one of my favorite proxies is the Nation Financial Conditions Index (NFCI) created by the Chicago Fed. You can see the NFCI from 1971 to today below:
For anyone interested in the math I suggest following the link above, but broadly, the index is a combination of three sub-indexes that track risk, credit, and leverage in the US markets. You can see clearly on this chart that financial conditions (think liquidity) during the 70s energy crisis, the 80s recession, and 2008 global financial crisis trended towards tighter. During these times we also saw markets recede. Notably missing is a spike today. Recently the we’ve trended away from looser towards average as investors begin to have second thoughts on risk, credit, and leverage. Given the severity of the situation we’re in currently its not unreasonable to think the NFCI could trend towards levels seen in the past, coinciding with a decline in asset prices. Note this is a trailing index as it is updated weekly.
Unemployment
During recessions and depressions unemployment increases as revenue slides downward and companies reduce headcount to cut costs. Some companies are crushed even before they have a chance to take these measures. During the global shutdown in response to COVID-19 revenue has evaporated. Companies once who enjoyed healthy revenue streams are now doing startup-style burn rate calculations to determine how long they have to live.
We are just starting to see the impacts of this:
Note the extreme difference between the unemployment rate (4.4%) and the jaw dropping spike in weekly US jobless claims. Some suggest the current unemployment rate is closer to 15–20% — a rate not even seen on the last graph. The biggest takeaway here is that we’re at the beginning stages of finding out what the economic impact of this virus is, and all signs are pointing to it being like nothing we’ve ever seen before.
How did we get here?
The gains of the last decade have largely been powered by buybacks and dividends. Companies have capitalized on low interest rates and loose credit/risk tolerances to finance these stock buybacks with cheap debt. They then use the reduced float to boost earnings per share and this in turn boosts the stock price.
Additionally, over the same period dividends have been on the rise. These dividends have attracted yield seeking investors who were previously confined to the bond markets. The added demand has helped with upward pressure on asset prices.
A recession is the perfect storm to kill off these two trends. With revenues already falling, companies have suspended or terminated their stock buyback programs. Companies asking for government bailouts may even be mandated to do so. As companies protect cash to survive, dividends will be the next cut to make. Adding to this, it’s reasonable to assume those same yield seeking investors likely won’t hold on as the risk ratchets upward.
The Game Plan
Thinking back to the earlier scenarios, we’re betting that door number two is most likely given the current market outlook. The macro forces against the market are too great and the fundamentals are getting worse daily. Currently the market is trading at levels seen in the fall of 2019, a time when the bull market was roaring and there were no macro headwinds. The market has dropped and rallied but the real leg-down is likely yet to come.
To take advantage of this opportunity we’ve taken short positions against the S&P500 via $SPY and Russell 2000 via $IWM. In addition any sort of prolonged recession is likely beneficial towards our standing positions in gold and Bitcoin.
It is worth noting the elephant in the room that could prove this hypothesis incorrect, the Fed. It’s incredibly difficult to bet against someone with unlimited cash and that’s exactly what this play is doing. Should QE Infinity work these shorts will quickly be worthless. It likely the flip side of this scenario is rampant inflation and/or a currency crisis but that is a topic for another time.
Fund Performance to Date
In the interest of transparency we will post fund performance metrics and an allocation chart in every blog post. Mizu Capital may hold positions in the assets discussed.
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