The people that I know who are the most successful at trading are passionate about it. They fulfill what I think is the first requirement: developing intuitions about something they care about deeply, in this case, trading… They develop a deep knowledge of whatever form of analysis they use. Out of that passion and knowledge, their trading ideas, insights, and intuitions emerge. ~ Charles Faulkner

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Good morning!

In this week’s Dirty Dozen [CHART PACK] we look at the broadening top in the SPX and add to the case that we’ve put in a short-term bottom and cover some of the liquation values on offer in global markets. We then talk about the troubling signs of a global recession on the horizon and what to keep an eye on as we go forward. And finish with a look at the global fiscal response, what it means, along with what the Fed’s done to relieve USD pressure, plus more. Let’s dive in…

***click charts to enlarge***

1. Last week I wrote about the deeply oversold levels, consensus negative sentiment, and how we should expect a bear market rally to soon begin (link here). The chart below shows the primary technical pattern I’m tracking. The S&P is bouncing off the bottom support of a large broadening top pattern. The percent of stocks trading above their 200 day moving averages fell below 5% for only the second time in 25+ years.

That marks extreme oversold conditions. Markets don’t move in straight lines. And especially now that the Fed has largely fixed the plumbing issues, minimizing liquidity gap risks. It makes me think we’re about to see a large multi-week rally from here. Watch to see where the monthly bars close on Tuesday. That will be a big tell as to where things are headed for April.

 

2. To add to the short-term bullish case, I’ve been seeing an across the board improvement in breadth and under-the-hood technicals to support a run higher. For example, the chart below shows the smoothed average daily advancers volume ratio for the Russell 3000. The red circles show the points which mark past selling exhaustion points followed by strong recoveries. Each time created at least a temporary bottom.

 

3. It’s wild looking at many of the valuations around the world right now. I can show chart after chart of entire country indices selling for 2stdev’s below their long-term average multiples. MSCI Asia Pacific stocks, for instance, are trading at liquidation levels, last seen at the depths of the GFC.

 

4. The Investors Intelligence Survey Bull/Bear spread turned negative for only the 6th time this cycle (h/t @Not_Jim_Cramer). The graph below from Bloomberg shows the following returns after the II spread turns negative.

 

5. While I’m positioning for an extended tactical bounce I’m expecting a severe recession and a new low in the market within the next 12-months. The market-implied probability of the US slipping into recession within the next year is now 92%.

 

6. Global car sales have fallen way below their long-term trendline as you’d expect. This trend had turned well in advance of the virus, driven by some changes to environmental standards in both China and Germany, along with just overall weakening demand in China. Thinking through things now, the big question is how long will this virus hang over us? Even if we can get R0 down to 1 or below within the next few months, will we have to worry about a second wave in the Fall? How will this affect consumer behavior, will we save more and spend less? Will companies hold back on CAPEX and slow hiring plans? (chart via Bloomberg).

 

7. According to Bloomberg, “Overdue credit-card debt swelled last month by about 50% from a year earlier” in China (link to the article here). The virus is having ripple effects throughout a very leveraged global economy. The article goes onto point out that “ In Australia, which has the highest household debt levels among G20 nations, the country’s largest lender said on Thursday that its financial assistance lines are receiving eight times the normal call volume. A similar surge in queries has flooded lenders in the U.S., where credit-card balances swelled to an unprecedented $930 billion last year and 3.28 million people filed for jobless benefits during the week ended March 21 — quadruple the previous record.”

 

8. If you look at total US market returns relative to NIPA profits, things still appear to be quite stretched; even after our recent haircut. I don’t see any reason why this chart couldn’t revert back to somewhere closer to its longer-term average, which would entail a much deeper bear market than what’s already occurred (h/t Macro Man).

 

9. Since the amount of BBB rated corporate debt is at all-time record levels here in the US. I think it wise to keep a close eye on BBB spreads as not just a gauge of sentiment but also a measure of where we are in the risk cycle. If I am right and we are indeed in the early innings of a bear market then we should see spreads continue to widen, even if equities go on extended rallies.

 

10. The fiscal and monetary responses to the virus have so far been impressive. I suppose that’s the benefit of policymakers still living in the event echo of the GFC and so are quick on the trigger. These are certainly bullish developments and why those of us who are of a more bearish bent at the moment, must hold our opinions weakly and update our views often. The chart and graph below from GS show the fiscal responses so far.

 

11. Bespoke Research published a great piece breaking down the actual dollar amounts that each income bracket will be getting from the announced US fiscal measures (link here). The short and sweet of it is, if you’re making below $50k then this is a great deal for you. If you were making above that, it’s less so. The expanded UI will make a huge difference to those at the lower ends of the income bracket.

 

12. I’ve been getting a lot of questions about the US dollar and gold lately. The US dollar had caught a short-bid for a while as markets panicked and we saw a dash for cash. The reason for this dynamic is that the world is essentially very short US dollars. The reason why is because most debt is USD denominated and so when there’s a risk-off environment that could threaten the cash flows needed to pay that debt we see the dollar get bid up.

Well, the Fed has done a tremendous job in recent weeks being quick to respond and opening up swap lines and supplying the market with much needed USDs. The chart below shows that the widening in EURUSD basis swaps has been reversed and bullish pressure on USD has been relieved. At least for a while.

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Stay safe out there and keep your head on a swivel!

***The following is an excerpt from a report sent out to Collective members over the weekend***

As for what I think now, I believe that the health, economic, and market impact of the coronavirus will be much greater than most people are now conveying. For example, the profit losses for businesses are likely to be many trillions of dollars so that governments protecting just the companies would cost a significant percentage of that amount of money. Additionally, the amount of money to protect just those individuals who will be devastated by the virus will also be enormous.

To do that, fiscal policymakers (I.e., heads of state and legislators) will have to create massive amounts of spending and distributions of money that will be distributed as “helicopter money.” That is happening now in many ways such as President Trump’s $1,000 checks to people. Where will that money come from? The fiscal policymakers don’t have that money because they don’t create it (the central banks create it), so they will have to borrow that enormous amount of money at a time when lenders don’t have much money to lend because most people and companies are losing money. That will drive up interest rates, which would be even more devastating for everyone. Central banks will then have to decide if they will let interest rates rise or print a lot of money to buy those bonds.

As they are faced with that choice, they will have no choice but to print money and buy a lot of government debt to hold interest rates down the way they did in the war years. So now all eyes are on central banks to see if they will do that. This is the big paradigm shift that I previously spoke about.

Ray Dalio wrote the above in a post on Linkedin this past week (link here). While Dalio has become somewhat of a whipping boy on the Twittersphere these last few weeks due to the walloping his Pure Alpha fund has taken, he’s dead-on in regards to the seriousness of the economic impact this virus will have on the world.

And while the future is multi-path dependent, we now have enough data points to know that what we’re living through is extraordinary, it will be talked about in history books 50-years from now. It’s a major paradigm shift that will reshape the world in unfathomable ways, both for better and worse.

While we’re going to cover some of the more immediate impacts today, let’s first do a brief overview of where we’re at in the progression of COVID-19 and what the current best-educated guesses are as to how the next 3,6, and 12 months will look.

I updated the COVID-19 Cheat Sheet a few days ago with the latest numbers and resources I’m tracking (here’s the link).

The situation is evolving quickly and there are so many opposing hot takes out there that it’s easy to get overwhelmed or point to data to confirm a bias. The reality is that no-one knows where exactly we’ll be in 6-months time, there’s just too much non-linearity to hold a hard opinion with confidence.

It’s a great time to put your Bayesian hat on and work on updating your priors daily because that’s how fast the information flow is changing. A useful shortcut for this is to regularly check in on the Good Judgement COVID-19 Dashboard (link here).

This is the forecasting project put together by Phillip Tetlock author of the must-read book Superforecasting. The predictions are updated daily and are “aggregated from forecasts by professional Superforecasters, who qualified by being in the most accurate 2% of forecasters from a large-scale, government-funded series of forecasting tournaments that ran from 2011-2015 and, since then, by being in the top handful of forecasters from Good Judgment’s public forecasting platform.”

This allows us to harness the wisdom of crowds, specifically the wisdom of a crowd that is particularly good at forecasting, to get a sense of how the severity skew of this thing is evolving. Here’s a summary of what the current median forecasts are projecting:

• • Between 53 million and 530 million total COVID-19 cases worldwide by March 31, 2021.
  • Between 800,000 and 8 million total COVID-19 deaths worldwide by March 31, 2021.
  • Between 2.3 million and 23 million total cases of COVID-19 in the US by March 31, 2021.
  • Between 35,000 and 350,000 COVID-19 deaths in the US by March 31, 2021.

These forecasts have been creeping higher over the last few weeks as more information becomes known. The range is considerable even within each bucket and that’s because the cone of plausible outcomes is wide and the situation is incredibly reflexive… much of the outcome is dependent on the actions we take now.

The most recent credible research points to two practical options for tackling the virus; neither of them painless. These are (1) mitigation and (2) suppression. Imperial College published a paper last week where they modeled the outcomes for each approach and discuss the pros and cons. Here’s a link to their paper as well as a link to a good laymen’s summary of their findings by MIT Technology Review.

I’ll explain the core of their findings here along with what we should expect as policy in the coming months.

• • Mitigation: This approach is focused on “flattening the curve” through targeted isolation of active cases and quarantining households.
  • Suppression: This approach uses a broad range of measures such as widescale shutdowns of non-essential businesses, forced at-home seclusion, and closing of all schools/universities.

Mitigation is intended to be a speedbump in order to buy the healthcare system precious time and spread out the onslaught of severe cases. Suppression aims to stop the virus dead in its tracks.

According to the findings of the paper, if the virus were just left to spread it would kill 2.2 million people in the US and 500 thousand in Britain by the end of summer. Using a mitigation strategy, they conclude that the two countries would at best be able to cut these numbers in half. And this doesn’t account for the higher fatality rate that would result from our healthcare systems being overwhelmed. Which, as the paper points out, would be catastrophic.

The Imperial College researchers found that even under the best mitigation strategy we’d still end up with a surge of critical care patients 8x larger than what the US or UK healthcare systems can cope with. The chart below illustrates this point. The red line is the current number of ICU beds.

This is why most countries are opting for the suppression strategy. Suppression is what China implemented in Wuhan and which brought the spread of the virus to a halt — at least temporarily and at a great economic cost.

One of the problems with this approach is that by keeping infection rates low it leaves many people susceptible to the virus. And as long as someone in the world has the virus, breakouts will keep reoccurring without drastic measures to control them.

Take the case of “Patient 31” in South Korea for example. South Korea did an excellent job of containing its initial outbreak but then a single infected patient unknowingly went on to infect hundreds of others, spawning another outbreak which led to the formation of many new clusters. The NYT has a great series of interactive graphs that show how easily this virus makes its way around the world (link here).

To avoid this, countries must ratchet up suppression measures each time the disease resurfaces. This is exactly what the team at Imperial College proposes doing. Every time admissions to intensive care units (ICUs) begin to spike, we enact extreme social distancing measures which we then relax once admissions begin to fall. Here’s how that approach would look.

MIT Technology Review explains the approach as the following (emphasis by me):

The orange line is ICU admissions. Each time they rise above a threshold—say, 100 per week—the country would close all schools and most universities and adopt social distancing. When they drop below 50, those measures would be lifted, but people with symptoms or whose family members have symptoms would still be confined at home.

What counts as “social distancing”? The researchers define it as “All households reduce contact outside household, school or workplace by 75%.” That doesn’t mean you get to go out with your friends once a week instead of four times. It means everyone does everything they can to minimize social contact, and overall, the number of contacts falls by 75%.

Under this model, the researchers conclude, social distancing and school closures would need to be in force some two-thirds of the time—roughly two months on and one month off—until a vaccine is available, which will take at least 18 months (if it works at all). They note that the results are “qualitatively similar for the US.”

As of right now, our baseline should be to expect roughly 18-months of rolling suppression measures. This is huge. Never in history has anything like this been done before. It’s going to stress the global economy and financial system in ways that’s never been seen. It’s also completely necessary as it’ll save the most lives and prevent our healthcare systems from total overwhelm.

Can this outlook change over the next month? Absolutely… we’re in unchartered waters and the situation is incredibly fluid. This is just the best guess we have at the moment and so should be our baseline; one we’ll continue to update daily as new info comes in.

The Volatility Machine: Small Business Balance Sheets

Macro is just an aggregate of what happens at the micro-level. And it’s at the micro where we’re most susceptible to cascading shocks.

Consider the following points.

The US economy is 80% service-based. This means much of our economy is dependent on in-person shopping, gatherings, face to face meetings etc…

Small businesses contribute roughly 45% to our GDP, comprise 88% of total businesses, and employ approximately half of the US labor force (charts from JPM).

Corporate debt as a percentage of GDP is the highest its ever been.

According to a study of US small businesses by JP Morgan, the median small business has less than 27 cash buffer days in reserve. And there’s a wide variance amongst industries. Healthcare services hold roughly 32 days of cash in reserve, while at restaurants just 16…

The study concludes that “Many small businesses may not have enough cash to continue operations in the face of a month-long loss of cash inflows due to an economic downturn or other negative shock”.

Put it all together and we get an economy that is largely dependent on social in-person interaction. It’s the most leveraged it’s ever been. Ever. In History. The average small business, which is the backbone of the economy, not only carries a lot of debt but also has less than a single month in cash reserves. We’re about to practice extreme seclusion — meaning no non-essential in-person interactions outside the home and closure of all non-essential businesses that require a physical presence — on a rolling basis for possibly 18-months.

At an even more micro level, according to another report by JP Morgan, the typical US household — who’s also very levered up — holds less than $4000 in liquid assets. And here, just like small businesses, there’s wide dispersion and the data paints a stark reality. Nearly 30% of US adults have absolutely zero savings and only 1 in 4 have a rainy day fund but one that’s not enough to cover three months of living expenses.

At its roots, an economic system is just a collection of interlocking balance sheets. The more levered these balance sheets are the more dependent on cash flows the system is (ie, fragile). This is why it’s PARAMOUNT that governments act aggressively and quickly. Because it won’t take long for a feedback loop with disastrous effects to ripple through the system.

Even then, I’m not so sure they’ll be able to pull it off. The system is simply too large and too complex. And the potency of the cure that is needed will almost surely have unintended negative consequences — economic iatrogenic as Taleb might say.

I’ll be writing more on this in the weeks ahead. A particular point of interest and an area where I think will be the epicenter of this crisis, in more ways than one, is China. There are increasing signs that the property market may be beginning to falter. The government has exhausted its ability to leverage its way out of problems and the PBoC is buttoned in by the classic Mundell Flemming Trilemma.

Said another way, it’s going to be a long and wild ride in macro land. Better buckle up…

***The following is an excerpt from a report sent out to Collective members over the weekend***

Updated: March 19, 2020

In light of the many disparate and conflicting opinions out there, especially on the Twitters… I thought I’d put together a comprehensive coronavirus cheat sheet with the key numbers, best resources, and info that I’ll update regularly. 

What it is: The virus is a respiratory disease caused by a novel (new) coronavirus which was first detected in China and has now spread to more than 188 countries. The virus has been named “SARS-CoV-2” and the disease it causes is “coronavirus disease 2019” or “COVID-19” for short.

Resources: 

• Johns Hopkins CSSE 
• Worldometers / Coronavirus
• CDC Coronavirus
• The Virus Watch
• Health Weather
• MUST-READ “CORONAVIRUS: Why You Must Act Now” 
• Retail Impact Tracker
• Superforecasting Tournaments: 
  • Good Judgement COVID-19 Dashboard 
  • Global death toll of COVID-19 before 2021 – median forecast: 1.98m
  • Total confirmed COVID-19 cases in US by April 27th   – median forecast: 481k
  • Total global COVID-19 infections by 2021   – median forecast: 407m
• Twitter Follows:
  • @mlipsitch – Infectious disease epidemiologist, Harvard
  • @sciencecohen – Science reporter focused on infectious disease / public health
  • @ScottGottliebMD – Former FDA commissioner and resident fellow at AEI

Key Numbers: These are the key metrics I’m tracking to discern the virus’s ultimate impact. 

Active Cases: This is the number of active coronavirus cases that are currently being treated globally. Why is this number important? Unlike the Total Cases number, which is what’s mostly being reported in the news, active cases leave out those who’ve died or have been successfully treated for the disease as they are no longer contagious.

Total active cases globally are currently 134,399 infected patients and climbing rapidly. This number should be expected to increase significantly in the coming weeks given the low levels of testing still available in the US and other parts of the world. 

This graph shows the arc of confirmed cases as well as the doubling period for each country. Total cases are currently doubling in the US every 2.5 days.

 

R0 (pronounced R-nought): Is the “attack rate or transmissibility (how rapidly the disease spreads) of a virus is indicated by its reproductive number, which represents the average number of people to which a single infected person will transmit the virus (worldometers).” For example, an R0 of 3 means that on average an infected person will infect 3 other people. As a rule of thumb, epidemiologist believe that any novel disease with an R0 believed to be over 1 should be taken seriously.

Current estimates put the coronavirus’s R0 somewhere between 2 and 2.5 though some early estimates put it as high as 3.8, which would be catastrophic. For comparison, the R0 for the common flu is 1.3 and the R0 for the 1918 Spanish Flu epidemic was thought to be around 1.8-2.0. 

Influenza viruses are genetically variable, and transmissibility difficult to predict especially early on in an epidemic. The RO value can change significantly over time and vary greatly across geographical locations.

Fatality Rate: The Case fatality rate refers to the “proportion of people who die from a specified disease among all individuals diagnosed with the disease over a certain period of time. The case fatality rate typically is used as a measure of disease severity and is often used for prognosis (predicting disease course or outcome), where comparatively high rates are indicative of relatively poor outcomes (Encylopedia Britannica).”

Estimates of the coronaviruses case fatality rate have so far varied widely, from a low of 0.5% to as high as 8%. Today the World Health Organization announced that the virus’s fatality rate is 3.4% but this rate is likely a huge overestimation due to “severity skew” in the reporting.  The credible consensus is that the rate will move lower as testing becomes more broad-based and cases of milder under-reported symptoms are factored in. The fatality ratio also differs greatly across age groups and initial health, with the ratio being much higher amongst the older population and those with a compromised immune system.

Ben Thompson, of Stratechery, made an important observation about the virus, writing: “It seems likely the fatality rate is lower than what was reported in China. Consider the failed quarantine of the Diamond Princess cruise ship, which allowed for a controlled sample. According to the latest numbers from Japan, of the 3,711 passengers and crew members on board, 705 were infected; of the 705 infected, 392 were asymptomatic; six have died. That is an infection rate of 19.0% (10.6% with symptoms), a fatality rate of 0.8%, and a mortality rate of 0.2% (fatality rate is what percentage of the people who are infected die; the mortality rate is what percentage of the overall population die)… This is mirrored in South Korea, which is experiencing the largest outbreak outside of China — at least the largest outbreak that we know about. This is an important caveat both because some countries may be worse (particularly Iran), but also because the South Korean numbers, thanks to the country’s excellent infrastructure, health care, and free press, are likely to be amongst the most reliable in the world. There the fatality rate is 0.4%, even lower than the Diamond Princess.”

Thomas Pueyo’s analysis of the most recent data suggests that the Fatality Rate will vary from 0.5% (South Korea) to 0.9% (China exl. Hubei) for countries that are prepared. For countries that are not prepared (ie, have limited medical capacity/supplies, are slow to act etc…) will have a fatality rate between 3% and 5%.  For comparison, the fatality rate for seasonal flu is less than  0.1% in the US. 

 

The fatality rate varies greatly by age (source). 

You can use this interactive graph from NYT to see how many fatalities we should expect in the US with various infection and fatality rates and how those compare with other major killers.

Here’s a chart showing the projected deaths per 300 million US population with various case fatality rates and R0s (chart via CDC).

And historical comparisons via the NYT.

Risks:  A critical risk here is that the US healthcare system is already taxed during flu season and an additional widespread virus could create a “double flu pandemic”. 

We have roughly 800k staffed hospital beds in the country. This finite capacity already becomes maxed out during a bad flu season. If the coronavirus spreads quickly in the US while the flu season is still in full swing then it’ll likely result in severe flu cases not receiving ideal treatment and a  tick up in the fatality rate.

This same idea holds for medical supplies, the NYTimes points out that “Public health experts are also closely watching reserves of vital medical supplies and medications, many of which are made in China. Some hospitals in the United States are already “critically low” on respirator masks, according to Premier Inc., which secures medical supplies and equipment on behalf of hospitals and health systems. And China is the dominant supplier of the raw ingredients needed for penicillin, ibuprofen and even aspirin — drugs taken daily by millions of Americans and dispensed routinely to hospital patients.”

For those of you in our Collective, I highly recommend reading the threads by @Jdavidr who’s an MD with decades of experience in this area, talk about the potentially massive stresses that this virus represents to our healthcare system and how we can best prepare. 

 The positive news is that March is the last month of peak flu activity. 

 

Additional Color:

• Vaccine: Credible estimates put a vaccine for the coronavirus 18-months out at the earliest.
• Warm weather: Scientist suggests it’s too soon to know how the virus will behave in warmer climates.
  • But “Viruses that cause influenza or milder coronavirus colds do tend to subside in warmer months because these types of viruses have what scientists refer to as ‘seasonality’”. This is due to a number of suspected reasons, such as: 
    • “Studies outside the lab show similar results, though some tropical regions have more cases of flu during rainy season, when people also cluster indoors.”
    • “Scientists hypothesize that low humidity, which often occurs in winter, might impair the function of the mucus in your nose, which your body uses to trap and expel foreign bodies like viruses or bacteria. Cold, dry air can make that normally gooey mucus drier and less efficient at trapping a virus.”
    • Ian Lipkin, director of the Columbia University’s Center for Infection and Immunity, has been studying the novel coronavirus. He says sunlight, which is less abundant in winter, can also help break down viruses that have been transmitted to surfaces. “UV light breaks down nucleic acid. It almost sterilizes [surfaces]. If you’re outside, it’s generally cleaner than inside simply because of that UV light,” he says. Via NationalGeographic.
• Second  Wave: Many epidemics have more than one peak. This is because following the initial outbreak, authorities work hard to restrict movement and limit the spread of the virus. Eventually, they relax these restrictions as people need to work to keep the economy from going into a tailspin. A second wave typically follows. Pay close attention to China where authorities have started to put greater emphasis on restarting the economy versus containing the virus.

H7N9 Bird Flu illnesses and deaths from Feb 2013 to Feb 2014 (link here).

H1NI positive tests reported to the CDC in the US from April 2009 to Nov 2009 (link here).

Spanish Flu: “There were 3 different waves of illness during the pandemic, starting in March 1918 and subsiding by summer of  1919. The pandemic peaked in the U.S. during the second wave, in the fall of 1918. This highly fatal second wave was responsible for most of the U.S. deaths attributed to the pandemic.”

When asked what he does differently than other traders, Bruce Kovner responded with (emphasis by me).

I’m not sure one can really define why some traders make it, while others do not. For myself, I can think of two important elements. First, I have the ability to imagine configurations of the world different from today and really believe it can happen. I can imagine that soybean prices can double or that the dollar can fall to 100 yen. Second, I stay rational and disciplined under pressure.

The ability to imagine configurations of the world different from today and really believe it can happen. That’s one of those things that is easy in theory but hard in practice. We have our cognitive wiring to thank for that.

We form most of our opinions using System 1 thinking, which is more instinctive and emotional. When confronted with complexity, System 1’s M.O. is to just extrapolate… take the recent past and project forward. Most of the time this works, which is why we evolved the trait. But… every once in a while our reality drastically shifts, we enter a new paradigm and the rules that once applied no longer do.

Here’s a graph I’ve shared over the years to help illustrate the point.

Now, this truth applies not just to markets but to how we think about reality itself. Our government, our security, social and economic norms, etc… everything that makes up our everyday reality we eventually learn to take for granted, think what has been will always be, and go on with our lives —  ignorance is bliss and all that. And, as I said, the vast majority of the time this is the right way to live.

Except, and any student of history knows this, there’s a long ebb and flow throughout time, where things change imperceptibly slow until all of a sudden an entire civilization wakes up to a new paradigm with new norms, new rules, new risks.

In markets, most investors lose a lot of money in a paradigm shift. While a small few make a killing.

The question obviously then is, are we experiencing a paradigm shift today?

I’ve always agreed with Yogi Berra that “It’s tough to make predictions, especially about the future.” Luckily we don’t need to try and divine what’s to come, but rather just follow Kovner’s lead and imagine configurations of the world different from today.

And that’s what we’re going to be doing in a series of pieces that I’ll be putting out in the weeks ahead. There’s no doubt that we’re in uncharted territory right now, with nearly half the developed world set to go into total lockdown in order to delay the spread of a novel virus.

But from an investing standpoint, the critical question is whether this virus will serve as a catalyst that will catapult us into a new paradigm or if it will be limited to being a severe yet temporary shock that will be counteracted by stimulus which will return us back to trendline growth.

That’s the $80trn question and one we’ll be exploring in-depth, in the days ahead.

Buy the dip, sell the rip

So it looks like I may have been one day early in my “Buyable Dip” call. Trump, after his horrendous public briefing on Wednesday and the market’s cold response, finally seems to be getting his act together and giving this pandemic its due respect — at least somewhat.

With the market deeply oversold and sentiment at about as bad as it can get, it was looking for any excuse to rally, so rally it did following Friday’s orchestrated presser (chart below is a weekly).

SentimenTrader’s Smart/Dumb Money Confidence Spread hit a level it’s only seen three other times in 20-years. But, as you can see — and this is very important — while these extremes in sentiment led to a short-term bottom in the market, none of them marked a major low.

I point this out because for all the record-breaking carnage we’ve seen over the last few weeks in markets… and let’s be clear, we’ve seen a number of once in a hundred-year type moves… there still seems to be a good deal of complacency.

Here’s something I’ve been thinking about.

Back in late Dec 18’/Jan 19’, I wrote a number of bullish pieces saying to buy the dip hand over fist. The feedback from readers was pretty much universal ridicule… I was told I was being a sheep and that a recession was a sure thing. Friends and family were texting me asking me about how to protect their portfolios from the coming crash. #RECESSION2020 was a trending topic on Youtube with all the major social influencers talking about it.

Now here we are, one year later, the market just declined roughly 30% in one of its most violent sell-offs in history. A new virus is spreading like wildfire across the world leading to entire countries shutting down; something that’s never happened before… And all I’m seeing on Twitter is people quoting Buffett and Rothschild talking about buying “when there’s blood in the streets”.

I’m here in Austin and a lot of my social group is made up of cops and firefighters. We were all having dinner together at a friends house last night — I know, I know, breaking social distancing rules — and literally, each one of them asked me what I think about these markets but they prefaced their questions with, “now’s a really good time to buy, isn’t it?”. Half these guys bought bitcoin in Dec 2017…

I get the feeling that we’re all kind of whistling past the graveyard. There’s been a paradigm shift but we’ve been lulled by recent history into expecting this dip to be bought too.

I don’t know, maybe these brave bulls will end up being right and the market will be making new highs in a few months, fueled by the Game Masters firehosing liquidity into the system and we’ll look back at this period and laugh about how panicked we all were.

But from where I’m standing, at this moment in time, I don’t see how you can think that with any reasonable level of confidence. I mean, it’s all odds and probabilities, isn’t it? And to me the odds —- and I say this with a big dose of humility as the cone of plausible outcomes is incredibly wide still — favor a recession within the next 12-months and sideways volatile action with a downward bias over the near/intermediate-term.

Anyways, that’s just my quick two-cents. We’ll be exploring this topic more in the days to come.

Right now, the odds favor a multi-day to multi-week rally in the SPX. I’m looking for a retrace to the fib 50-to-61.8% level, really anywhere in the white circle range around its 200-day moving average (yellow line).

A move below Friday’s low would obviously negate this interpretation. The FOMC meeting is on Wednesday and the market is currently pricing in a 100bps cut from the Fed. If expectations are met, then this should serve as fuel for the rip higher. And if not, then that could be enough to throw some cold water on things.

I’ve upped our Core equity position from flat to 25% and plan to hold it until our target is hit or Friday’s lows are taken out.

Gold: The non-hedge

We got lucky with the timing of our short gold position last week. I’m moving my stop up to breakeven on the position and will look to add to it on a breakdown from a bounce. And we should see somewhat of a bounce as the barbaric relic is below its lower Bollinger Band and at its 200-day moving average.

If equities rip as I expect them too, then we should see bonds and gold move just as fast but inversely so.

As for single stock names, I’ll likely add some swing long positions tomorrow. Here’s a shortlist of some names I’m thinking about (link here).

Shipping stocks, tankers especially, are at the top of my list. The bull case for tankers that I laid out my last note is only getting stronger. I’ll be adding a starter position in TNK on the open tomorrow. And LPG, which we bought into last week, finished Friday up 20%. We’ll have to size TNK small because of the volatility but should get some more opportunities to add in the weeks ahead.

Remember, the key in this environment is defense. PROTECT YOUR CASH. Stay nimble, fallible, respect your stops, size small, and take your losses quickly.

I’ll be posting my trades as I make them in the #mo-trade-updates channel in our slack so make sure to periodically jump in there and check up on what I’m doing.

And, as always, if you have any questions don’t hesitate to shoot me an email or DM.

And also, if you haven’t already, click this link and check out our Collective. We’re keeping the doors open for a few more days. If you’re passionate about the game of markets then the Collective may be a good fit for you.

It’s hands down the best collection of investors and traders on the interwebs. It’s where I share my research, all our work on theory and investing strategy, and also where we stress-test each other’s ideas. Our internal slack is comprised of active traders and investors from around the world, comprising every level of skill; from billionaire HF managers who are household names to young gun college students hell-bent on learning the game. So take some time and check us out.

Thank you for reading.

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***This is an excerpt taken from a note sent to Collective members over the weekend***

Wikipedia describes a cascade effect as “an inevitable and sometimes unforeseen chain of events due to an act affecting a system”.

A cascade effect occurs in markets when an event or connection of events kickstarts a positive feedback loop, which then goes on to dominate price action until it burns itself out and the process goes into reverse.

George Soros touches on this particular dynamic in his book “The Alchemy of Finance”, writing:

At any moment of time, there are myriads of feedback loops at work, some of which are positive, others negative. They interact with each other, producing the irregular price patterns that prevail most of the time; but on the rare occasions that bubbles develop to their full potential they tend to overshadow all other influences.

In today’s piece, we’re going to explore the increased potential for major cascading effects in markets and the global economy. And we’ll finish with a discussion on how we can best position ourselves to manage this increasingly uncertain environment.

To kick things off, I want to go over some of the key points covered in Bridgewater’s roundtable discussion titled “Assess the Coronavirus” that was released last week since it serves as a useful roadmap for our discussion today.

If you haven’t seen it, here’s the link. It’s 22 minutes long and worth watching in its entirety. Below is my paraphrasing of their discussion on the potential coronavirus impacts on markets and the economy.

• • We already know the global economy is going to take a major hit in Q1. The big question going forward is how long will this impact last?
  • Historically, most pandemics have tended to have shorter-term impacts on the economy. These were then followed by very strong recoveries due to global monetary and fiscal responses.
  • The key determinant however in whether a shock comes and goes or cascades into a longer-term impact is whether or not it flows into the credit system.
  • If it doesn’t have a second-order impact in creating credit problems then its ultimate impact will be muted.
  • Two things are true right now
    • (1) Never before in the history of the world have central banks been more plugged into the global financial system and able and willing to provide liquidity to where it’s needed.
    • (2) At the same time, the world is holding record-high levels of debt and the efficacy of monetary policy going forward is limited with rates already at the lower bound and the world flush with liquidity.
  • We know we’re going to see a large Q1 global shock. What matters is how things play out from there… how does the virus spread, how do people and governments respond, etc…
  • Key questions going forward:
    • China’s coronavirus outbreak followed a temporal arc. This led to a dramatic slowdown in China’s economy but now that the infection rate has dropped, its economy is beginning to recover; albeit slowly and from very low levels.
    • Does China experience a second wave of infections as people go back to work?
    • Do the arcs in other countries play out like the one in China?
  • Markets tend to under discount events in the beginning and over discount them as they mature.
  • When trying to discern the implied impact of profits that the market is pricing in, it’s difficult to say what’s due to profit expectations and what’s due to a change in risk premium (the premia spread of equities over other assets, such as bonds).
  • Bridgewater thinks the market is pricing in roughly a 20% decline in earnings across global markets for the entire year, as a result of the virus.
  • Looked at another way, if you don’t assign half the impact to risk premium then the market is pricing in a 40% decline in earnings for the year.
  • That’s a large impact being discounted when compared to past pandemics unless this one ends up being closer to the Spanish Flu in its economic severity.
  • So a big ongoing economic impact and hit to profits are already priced into global markets.

The market has already discounted a big drop in profits for the year. This discount is much larger than past pandemics outside of the 1918 Spanish Flu. This means stocks are cheap here as long as the economic impact doesn’t feed into the credit system and cause a cascade in the credit markets.

There’s lot of big ifs here… That’s to be expected since the cone of plausible outcomes has been blown wide by this virus. This is fine. Our job here as traders and investors is not to try and predict the future but rather to be informed of the various possible outcomes, know what characteristics are unique to each one, and formulate a game plan for all.

This is Bruce Kovner’s trick that helped him to become one of the greatest living traders. He said:

One of the jobs of a good trader is to imagine alternative scenarios. I try to form many different mental pictures of what the world should be like and wait for one of them to be confirmed. You keep trying them on one at a time. Inevitably, most of these pictures will turn out to be wrong — that is, only a few elements of the picture may prove correct. But then, all of a sudden, you will find that in one picture, nine out of ten elements click. That scenario then becomes your image of the world reality.

Let’s start with a look at credit markets, which after this weekend’s news of the OPEC+ breakdown, is facing a double whammy of sorts. And this is troubling since they’re already in quite the precarious spot as I’ll show you.

Mohammad El-Erian, an economist (and one of the few that I actually find is worth listening to), wrote in an op-ed last week for the FT about the dangers lurking beneath the surface of the US debt markets, saying (emphasis mine):

Sudden sell-offs in markets have a nasty way of exposing vulnerabilities that take on a disruptive life of their own, and risk amplifying the initial shock through a self-feeding cycle.

It is important to remember, in this context, the large amount of US investment-grade corporate debt that hangs over the high-yield market like a Damoclean sword. Much of it is now facing a considerably higher risk of downgrade, given the inevitable global economic slowdown caused by coronavirus.

The greater the movement down to junk status, the higher the risk of a waterfall of funding dislocations that makes everything worse, financially and economically.

Years of easy money and financial leveraging have led to high profits and an enduring bull market. But the thing about operating leverage is that it’s a sharp knife which can cut both ways. The severity of which is susceptible to exponential shocks simply due to the size of the numbers we’re talking about. According to Blackrock, the US corporate bond market is over $10tn size, 5x larger than it was two decades ago.

El-Erian goes onto explain what this could mean for the bond market, writing:

The result is that corporate debt has risen significantly faster than earnings growth and cash balances, resulting in a significant downward ratings migration that now has half of the total investment-grade market clinging to that status with a triple B rating, up from less than one-fifth in 2001. Among the companies on that bottom rung, a third are already rated triple B minus, and thus at greater risk of a downgrade to junk.

The likelihood of a growing number of “fallen angels” comes at a time when the longstanding structural deficiency of the $1.2tn high-yield market — that is, a small base of dedicated investors, relative to the amount of outstanding bonds — is more apparent. Liquidity stress could be exacerbated by a lack of funds willing to cross over into junk territory, put off by sudden spikes in credit spreads and less-friendly trading conditions.

Now, both companies and investors must navigate the economic and financial effects of the coronavirus that heighten credit risk while sucking liquidity out of the bond markets. The longer it takes to contain these spillovers, the larger the credit downgrades, the higher the threats of default — and the greater the likelihood of financial markets contaminating the economy.

Debt ultimately creates fragility in the system. It makes it the entire system much more susceptible to shocks and non-linear cascading effects — feedback loops run amok. As El-Erian points out, Fallen Angels — investment-grade getting downgraded to junk status — is not a simple step function event. Mandates and regulations mean that a mass downgrade from IG to HY would create large forced selling as most holders of IG can’t legally own HY paper. This would create more downgrades and liquidity seizures within the market, thus spawning a feedback loop with menacing results.

The coronavirus has the potential to be an angel killer.

The virus represents two major shocks to the system. Both a supply shock and a demand one. Credit Suisse’s financial plumbing expert Zoltan Pozsar hit on a crucial point in how the virus affects the credit system through the supply chain, writing (emphasis by me):

Debt is agnostic to your circumstances – it must be serviced, otherwise you are bankrupt. Factory closures and an abrupt halt in the assembly and shipment of final goods and quarantined metropolises therefore matter for firms as debts must be serviced regardless, and if dollars don’t flow in from sales and payments, they have to be raised from banks.

…“the supply chain is a payment chain in reverse” and when output is not being shipped, the assembler/seller of final goods in China does not have inflows to pay the suppliers of intermediate goods, so firms in Japan, Korea and Taiwan are not having inflows either – every firm along the chain starts to become a deficit agent.

Beyond the initial deficit entry – not getting paid for components already shipped – deficits will multiply over time due to fixed costs. Think about servicing assets – plants, offices, ships, other transportation fleets – and servicing the debt that’s financing these assets.

The question is how much financial damage is done by the current IP [industrial production] shock and the fact that it coincides with a shock in services – a sector which is seldom volatile or cyclical. Missed payments in manufacturing are one thing. Missed payments in manufacturing and services at the same time are another.

Our global supply chain has been optimized over decades for just-in-time manufacturing. The virus has exposed the vulnerabilities of such a system. Another consequence is that it’s also resulted in a global just-in-time payment system.

The difference is, that when the just-in-time manufacturing system breaks down, companies don’t get their needed parts and a supply shock ensues… while when a just-in-time payment system gets jammed up debt payments are missed, loans go into default, and the credit system grinds to a halt.

Combine these stresses with the spread of government-enforced social-distancing and mass quarantines that we’re starting to see implemented in countries outside of China.

Take Italy for example, they’ve just quarantined the entire Lombardy region…

So you know what a big deal this is, the Lombardy region, and it’s capital Milan, is the engine of the Italian economy. It’s home to over 16m people… A population twice the size of NYC’s is now banned from “entering or exiting the area and also movement inside it won’t be allowed if not for “undeferrable” business or health reason… the so-called ‘security zone’ restrictive measures will include school closures and suspending skiing and public events, and closing museums, swimming pools, and theatres… Bars and restaurants will have to maintain a distance of at least a meter between people or will be closed. Work meetings have to be suspended” according to a report by Bloomberg.

Whether or not these are overreactions are irrelevant. Similar actions are coming to a city near you.

The reason: incentive cascades.

We live in a social media amplified world where the global mob greatly increases the costs of not overreacting to a disaster. God help you if you’re the one University President, City Mayor, or Company CEO that doesn’t take the drastic actions your peers implement and that subsequently results in a single death from the coronavirus. You can go ahead and kiss your job goodbye… you’ll be chased out of your position by a mob of hysterically righteous twitter justice warriors.

How long can our over-indebted service-based economy weather a mass social-distancing storm? I don’t know the answer to that question but I can tell you that the credit market will figure it out before anybody else does.

Indices such as Markit’s North American CDX Investment Grade Index have gone vertical in recent weeks as they begin to sniff out the repercussions here.

Bloomberg Barclays High Yield Credit index is at its third widest point in its history.

WTI Crude finished last week at $41.28. The average breakeven for a US fracker is $50/bbl.

We’re experiencing the largest commodity demand shock since 2008 right now. Goldman Sachs estimates that the “unprecedented disruption to economic activity in China has resulted in an estimated 4 million b/d of lost oil demand compared to 5 million b/d during the Great Recession in 2008/2009.”

What a time to start a pricing war in oil…

Over the weekend, Russia essentially pulled out of OPEC+. The Sauds were arguing for further production cuts to match the decline in demand. Russia said no. The Ruskies don’t want to facilitate favorable conditions for US producers who continue to boost output.

Mikhail Leontiev, a spokesman for Rosneft (a large Russian oil producer) told Bloomberg reporters following the meeting that “If you always give in to partners, you are no longer partners, It’s called something else… Let’s see how American shale exploration feels under these conditions.”

Russia’s estimate breakeven price is around $45 and the country has built up reserves over the last few years and can manage an extended price war.

The House of Saud is not taking this lying down and it looks like they’ll be responding in kind. Saudia Arabia announced that it plans to boost its oil output to well over 10m barrels a day next month. They also went and slashed their pricing by the most in 30-years and according to Bloomberg, “Saudi Aramco is offering unprecedented discounts in Asia, Europe and U.S. to entice refiners to use Saudi crude.”

I can’t even begin to tell what a big deal this is. The combined supply and demand shock to the oil markets make sub $30 oil not just a possibility but a probability… That’s huge and its repercussions are going to be far-reaching.

And this all couldn’t be coming at a worse time for US shale producers who have a staggering $100bn in debt and interest payments coming due over the next 6-years. Over 60% of the debt that matures over the next 4 years is speculative. No way these companies are going to be able to refinance and roll over these debts… Not in this environment.

This means we should expect wide-scale defaults and belly ups in energy space. Russia just basically took a kill shot at US producers and hit them square between their leveraged cash-burning oily eyes…

There’s going to be some incredible deals once the smoke clears. I’m chomping at the bit because there are some fantastic companies in the space. One’s with Fort Knox like balance sheets, and incredible assets that produce strong FCF. But we need to be patient here as this will almost certainly be a baby getting tossed out with the frack water situation.

And this, of course, brings us back to one of our original questions which is whether or not we see a credit cascade result from all of this. While lower oil prices certainly benefit the American consumer, I expect the shock to the economy and subsequently the credit market to far outweigh the benefit of lower prices at the gas pump.

Will that be enough to tip us over the edge…  to kickstart a feedback loop of liquidation? Or will the virus burn itself out in the next couple of months, and stimulus from the Game Masters (central banks and governments) suffice to keep the system from locking up, thus setting up markets for an incredible buying opportunity?

Only time will tell…  Until then, we need to keep managing our risks and listen to what the market is telling us.

You can’t build in a feedback or reactive model, because you don’t know what to model. And if you do know — by the time you know — the odds are the market has changed. That is the whole point of what makes a trader successful — he can see things in ways most others do not, anticipate in ways others cannot, and then change his behavior when he starts to see others catching on. ~ Richard Bookstaber

Portfolio Review

Our portfolio is up 12.5% ytd. We’re currently net short in our equity book after adding the new positions last week.

Bonds have been a big producer for us since the start of the year and we continue to sit in our 50% Core position. If the market looks like it’s putting in an intermediate term bottom which could happen in the next few days or weeks, then I may consider taking full profits.

The one change I’m making is I’m getting back into gold and upping my position to 50% of NAV after going flat the other week. Gold finished strong on Friday and if we see more follow through in the days ahead, then it likely means gold is resuming its bull trend.

Regarding the equity positions. I’m going to be quick to cut and minimize risk should my longs look like they’re going to dip or my shorts rip. I’m not looking to get overly cute in this environment. Priority one, is playing defense here and protecting capital while we wait for some setups.

Thank you for reading.

***Due to a number of requests over the past week, we’ve opened up the doors to our Collective. If you’re interested in joining our group, which has been referred to as “the most elite collection of traders and investors on the internet”, then just click the link below. If you have any questions, don’t hesitate to shoot me an email at alex@macro-ops.com. We’ll probably close the doors on this enrollment period sometime the next few days***

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