Last week’s price action underscored that despite the aggressive rebound off March lows, a degree of fragility remains. Of course, markets are all about 2-way price action and it is fair to say, prior to last week’s sell off, price action had been very one-sided, with sentiment and positioning reaching extremes. Bankrupt companies were flying, the put-call ratio was close to 10-year lows and sports betters were morphing into fully-fledged portfolio managers. Speculation was rife and complacency a foot. However, the pullback we saw on Thursday, although warranted given extremes in positioning, revealed more than just the extreme speculation driving markets higher in recent weeks. The realised move in the S&P 500 was far greater than the implied daily move in the S&P 500 from the VIX index. Here, there are a number of conclusions we can draw:
- We know markets are not normally distributed in any case, but last week’s 4 standard deviation move in the S&P 500 confirms active fat tail risk is in play
- Despite meeting the technical definition of a bull market (20% off lows), price action is not characteristic of a secular bull market, revealing an underlying fragility
- As my colleague Peter Garnry notes, VIX not indicative of a bull market
- Combined, we urge caution.
However, these are unusual and uncertain times. We know that fundamentals are wildly disconnected from market pricing, something my colleagues and myself have discussed at length in recent weeks. However, does that mean we are ready to call time on the liquidity induced mania revealed in recent weeks.
At this stage we would argue that although fundamentals will eventually trump liquidity, the liquidity driven narrative has proved strong and tough to break, particularly as the lack of appealing alternatives and the expectation that rates will remain low for an extended period drives investors up the risk spectrum into equities (TINA). Conditioned by the central bank put to “buy the dip” these investors are reaching for yield and piling into risky assets (FOMO). The existence of this dynamic perversely dictates one need not be positive on the expectations of a swift economic recovery, to be long stocks (and by default short cash/efficient markets/price discovery). Post consolidation/retracement these factors are likely to remain key drivers of continued upside and will persist in lending an underlying support to risky assets.
As we said last Tuesday, prior to Thursdays sell off, for short-term traders, now is the time to tighten stops and book gains. We maintain this defensive stance on risk.
The news cycle has certainly turned for the worse and it is clear the world still has a COVID-19 problem. Fresh lockdowns in Beijing, an uncontrolled first wave in the US and EM’s (India, Peru, Brazil, Chile, Pakistan) struggling to control the pandemic locally corroborate a cautious stance. In Beijing, “The risk of virus spread is very high, and resolute and decisive measures are needed to prevent further spread,” vice premier Sun Chunlan said during a state council meeting on Sunday, as reported by state media.
Without a vaccine, as lockdowns are lifted a persistent and growing first wave presents a clear risk for a true second wave resuming in the Northern Hemisphere once colder weather remerges. This would be a real hurdle that extended valuations fail to reflect. These risks are now being more adequately considered, but for how long is the question. In the current paradigm, when the only bull market is in intervention, the cynic in me wonders how long until the newswire, “a vaccine is close” crosses!