What Now?, Reflexivity, What I Really Worry About...

March 18, 2020

How are you ? Is everything ok ?

I could stop there, since that’s the only thing that really matters.

A. What Now ?

To answer what happens now, we first have to understand where we are and how we got here. Let’s look at the type of financial crisis we might be going through.

There are typically two types of financial crises.

  1. Solvency Crisis

  2. Liquidity Crisis

What we are facing today, has some hints of a solvency crisis.

* The energy sector? The energy sector is sick. But it is now less than 4% of the MSCI World-an all time low-while. Will these bankruptcies allow the transfer of assets from weak hands (small over-leveraged E&P players) to strong hands (big oil)? And will there be big impairments to bank balance sheets? The first seems likely. The second is less so, given that bank lending to the energy patch has been relatively modest, partly because the shale boom of 2010-14 occurred when US banks were getting back on their feet after the 2008 crisis.

* Airlines and the travel industry? The policy responses may diverge significantly. It is likely governments will ride to the rescue of their flag-carrier airlines, with loans, subsidies and even outright nationalization. This may not be great news for shareholders, but there are few reasons to think airline losses will contaminate bank balance sheets. When it comes to hotels, restaurants and casinos, it is likely banks will show forbearance to companies that until now have been going concerns.

* Europe? European banks dodged a bullet in 2008-09, and again in 2012. Will they be as lucky a third time? Several European countries are entering the current crisis from a position of weakness. Even before Covid-19, Italy was on the brink of another recession. In France, restaurateurs, hoteliers and shop-keepers were already struggling with the impact of crippling pension reform strikes on top of the gilets jaunes protests. Then came Covid-19. With three successive blows likely to have depleted cash cushions entirely, swathes of small business bankruptcies are likely across Europe-which will impact the banks. In short, Europe is once again looking, and sounding, sick.

* Pension funds? Most Western pension funds were under-funded coming into this crisis. Nothing that has happened in recent weeks has helped this long term picture, and the collapse in yields only makes the situation worse.

But I think a liquidity crisis is much more likely because:

* New regulations. In past crises, investment banks would provide liquidity in turbulent markets, and make fortunes for themselves by doing so. However, the post-2008 wave of regulation has made this much more challenging. So, while financial markets have grown enormously over the last decade, financial intermediaries have shrunk. This may well be the cause of much of the market dislocation we are seeing today.

* Social distancing. Financial intermediaries, like most other businesses, are now having to cope with big upheavals in their working environments. Non-essential staff are working from home, or from disaster recovery sites. With teams scattered, it is easy to imagine that the willingness and ability of market makers to take risk is greatly reduced. This may explain the divergence we are seeing between ETFs and their underlying baskets, or the dislocations in corporate bond markets.

* Funds in trouble. As always when markets dislocate, rumors abound of hedge funds or banks in trouble. Undeniably, some market participants will have been caught wrong-footed (for example, one popular trade among European banks was to be long the undervalued Mexican peso and undervalued Mexican bonds-a trade which has seen a number of fixed income managers carted out feet first). Now the simultaneous fall in government bonds, equities and gold suggests a significant level of liquidation. From risk-parity strategies, perhaps? Or from leveraged quant-driven hedge funds?

If this really is a liquidity crisis, how do we get out of it ?

What do you think it is ?

B. What Could a Bottom look like ?

The August 2011 market crash and subsequent bottoming process could illustrate how the market environment could play out in coming weeks and months. While all market crashes have different reasons, the one thing that is very consistent is how human nature plays into it. There are three stages of behavior when the market crashes:

1. Panic – happens toward the end of the initial crash like what happened in Aug. 2011 and Monday of this week.

2. Relief – develops after the crash with a reflex rally as investors are simply glad it stopped going down.

3. Demoralization – when the market tests the panic low and even breaks it marginally similar to the drop in early Oct. 2011.

Source: Canaccord Genuity

C. The Power of Reflexivity…

Reflexivity is a theory that states that feedback loops between expectations and economic fundamentals can cause price trends that substantially and persistently deviate from equilibrium prices.

Which is to say that falling and rising prices can create their own reality.

This is even more important & pronounced in a financial market that is:

a) leveraged and interconnected;

b) portfolios are managed on the basis of VaR models;

c) the FED, other central banks and most market participants taking their cue from market prices - falling prices signal problems….

What this means is that an event that can cause prices to start moving in one direction or the other, can feed on itself.

This tightly wound financial world then interacts with the physical world that is also similarly tightly wound with:

a) global supply chains and just in time inventory;

b) businesses with operating leverage and fixed costs;

c) and optimized capital structures using buybacks and cheap debt

On top of this tightly wound financial world and physical world, sits a pool of index and passive investors which given their non-discretionary nature can amplify price action in either direction.

Which is to say rising prices usually lead to more money coming into that security or asset class, and falling prices usually lead to money flowing out of that security or asset class.

Let’s say for example:

That three weeks ago rates volatility picked up and hedge funds had to start deleveraging. Now typically in rates and credit markets funds run fairly leveraged but in prior times they could sell to a bank, but under Dodd-Frank and with COV-19 that market making is probably limited. At the same time, it’s not one hedge fund that is selling, it’s a few. And as funds can’t sell their rates positions they look for other things to sell to reduce their gross. This makes the vol of other asset classes rise too.

Still no new discretionary buyers have appeared, and those that have appeared pale in comparison to the size of selling that needs to happen as leveraged books move from a 15 VIX world to a 75 VIX world. And while volatility remains high, de-grossing must continue. But all that selling needed to happen when there are no real prices, because discretionary investors don’t want to step in front of this.

So prices fall, as assets change hands from week to stronger hands as new discretionary investors show up.

Meanwhile the FED sees all this price action, and thinks lower rates can fix the problem, and so as short end rates fall, it makes long end treasuries go up in price more, creating a further bid from both passive investors (as prices go up, they have buy more). At some point the credit investors who had been using treasuries as a hedge have to sell their treasuries because at those prices they don’t really hedge their books. As they sell their hedges, they are forced to sell down their credit book too, otherwise they would be unhedged.

I’ll stop there.

That’s just a snapshot of the potential cycle we have been in and might be coming out of.

It’s important to remember that equities are just a sideshow vs. the size of the commodities, rates, credit and FX markets that are much much much larger and more leveraged.

Karl Popper once wrote that risk is an inherent and unavoidable part of life. He went on to argue that if governments or civic institutions try to reduce risk at the individual level, it invariably increases risk at the global level. In essence, Popper laid the ground work for Hyman Minsky’s observation that stability breeds instability—usually through leverage.

After all, the more stable an asset class appears to be, the more tempting it becomes to goose up returns with leverage. But of course, the more leverage is added, the less stable things become.

But away from this, it is important to acknowledge that central banks are now flooding the system with liquidity, and that this liquidity will stick around once the pandemic abates.

All this makes me think that there is the possibility that what we are living through is a liquidity crisis, and that as the pandemic fears recede the markets will go back to pricing in a more normal economic backdrop, albeit with significant real economic & human damage done.

Soon, the the markets will have to incorporate in their pricing calculations the enormous amount of new monetary, fiscal, and energy stimulus in the system.

In the end, the markets are driven by the incremental news and the incremental buyer.

Just like reflexivity can spiral us downwards, it can also spiral us upwards.

Mike Green was on the Hidden Forces podcast discussing the role of passive investing and market structure in the melt-down.

D. What Would Howard Marks Do ?

From Mastering the Market Cycle by Howard Marks:

Finally in discussing how to detect and respond to market cycle extremes, I want to return once more to the widespread panic that followed the bankruptcy filing by Lehman Brothers in September 2008. 

Although the sub-prime mortgage crisis originated in a small corner of the financial and investment world, the impact was soon felt widely, particularly by the financial institutions that had underestimated the risk in mortgage backed securities and thus invested too heavily in them. As a result of the threat to these essential institutions, the impact metastasized to the stock and bond markets in all countries—and then to economies all around the world—in the form of the Global Financial Crisis. 

Thus, as I described earlier, money market funds and commercial paper had to be guaranteed by the U.S. government. A number of prominent banks and financial institutions failed or had to be bailed out/rescued/absorbed. No one knew how far the carnage would spread. The equity and debt markets collapsed. Now the generalizing was on the negative side: “the financial system could totally melt down” in a vicious circle without end. 

Since the generalizations were on the downside, the error-making machine went into reverse. No greed, only fear. No optimism, only pessimism. No risk tolerance, only risk aversion. No ability to see positives, only negatives. No willingness to interpret things positively, only negatively. No ability to imagine good outcomes, only bad. Thus we reached the day on which I had the discussion mentioned back on pages 131–132, in which the pension fund head was unable or unwilling to accept that any assumption regarding possible defaults could be conservative enough. 

What was the essential observation? Here’s what I wrote in “The Limits to Negativism” (October 2008): 

Contrarianism—doing the opposite of what others do, or “leaning against the wind”—is essential for investment success. But as the credit crisis reached a peak last week, people succumbed to the wind rather than resisting. I found very few who were optimistic; most were pessimistic to some degree. Some became genuinely depressed—even a few great investors I know. Increasingly negative tales of the coming meltdown were exchanged via email. No one applied skepticism, or said “that horror story’s unlikely to be true.” Pessimism fed on itself. People’s only concern was bullet-proofing their portfolios to get through the coming collapse, or raising enough cash to meet redemptions. The one thing they weren’t doing last week was making aggressive bids for securities. So prices fell and fell, several points at a time—the old expression is “gapped down.” 

The key—as usual—was to become skeptical of what “everyone” was saying and doing. One might have said, “Sure, the negative story may turn out to be true, but certainly it’s priced into the market. So there’s little to be gained from betting on it. On the other hand, if it turns out not to be true, the appreciation from today’s depressed levels will be enormous. I buy!” The negative story may have looked compelling, but it’s the positive story—which few believed—that held, and still holds, the greater potential for profit.

At this market cycle extreme, all the news truly was negative . . . and certainly not imaginary. The only questions I received were “How far will it go?” and “What will be the effects?” Given that asset prices reflected nothing but abject pessimism regarding these things—I’d say near-suicidal thinking—the key to profiting lay in recognizing that even in the face of uniformly bad news and a very poor outlook, pessimism can be overdone, and thus assets can become too cheap. 

It was the excessiveness of the prevailing pessimism that led me to write “The Limits to Negativism” at the credit market’s low ebb in October 2008. In it I pointed out, as mentioned in the chapter on attitudes toward risk, that the superior investor’s essential skepticism “calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.” That variety of skepticism was totally lacking in the market’s darkest days, of course. 

Shortly after Lehman’s bankruptcy filing on September 15, 2008, Bruce Karsh and I reached the conclusion that (a) no one could know how far the financial institution meltdown would go, but (b) negativity was certainly rampant and very possibly excessive, and assets looked terribly cheap. Thinking strategically, we decided that if the financial world ended—which no one could rule out—it wouldn’t matter whether we’d bought or not. But if the world didn’t end and we hadn’t bought, we would have failed to do our job. 

So we bought debt aggressively. Oaktree invested more than a half a billion dollars a week over the fifteen weeks from September 15 through the end of the year. Some days we thought we were going too fast, and some days too slow; that probably meant we had it about right. The world didn’t end; the vicious cycle of financial institution implosion stopped with Lehman Brothers; the capital markets reopened; the financial institutions came back to life; debt was again able to be refinanced; bankruptcies turned out to be very few relative to history; and the assets we bought appreciated substantially. In short, paying heed to the cycle was rewarded.

E. What I Really Worry About Longer Term

Something Peter Zeihan & Ian Bremmer have been talking about for a while, that I have also come to believe could be a bigger issue globally: is the fact that much of the global system as we know it – the system that has enabled everything from global manufactures trade to global energy trade to the existence of the European Union to the rise of China – is an American creation, designed for the Cold War.

That system was the payment to our allies to side with us against the Soviet Union. That system ceased serving American strategic interests at the Cold War’s end, and in the days before coronavirus it was coming to an end.

Coronavirus has sped things up, severing most of the remaining ties that bind the world together. No one else has the military capacity to ensure freedom of the seas, nor the demographic consumptive capacity to fuel global commerce. Since their economy is largely self-contained, the Americans really don’t care if the system collapses.

And that was before the coronavirus-induced fear response.

It isn’t clear to me that there is yet recognition of this fact in the wider world.

You can see an example of that belief starting to show up more and more often in the establishment - most recently in Nikki Haley’s (former governor of S. Carolina and UN Ambassador) tweet yesterday:

You can learn a lot more about this idea in this great podcast Peter Zeihan did on Invest Like The Best.

E. A Few Things Worth Checking Out

Five Years ago, Bill Gates did a TED talk discussing Why We Are Not Ready. He was right….

Quotes I’m Thinking About:

Let us not look back in anger, nor forward in fear, but around in awareness

- James Thurber

Things without all remedy, should be without regard, what’s done, is done.

- William Shakespeare

“We chase extraordinary moments instead of being grateful for ordinary moments until hard shit happens. And then in the face of really hard stuff — illness, death, loss — the only thing we’re begging for is a normal moment.”

- Brené Brown