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Why this volatility isn’t unprecedented

I have heard comments from veteran technical analysts who have become bewildered by the market’s action. The word “unprecedented” is often used. I beg to differ. The violence of the sell-off, and subsequent rebound is not an unprecedented event. Recall the NASDAQ top of 2000. The NASDAQ 100 fell -39.8% from its March 2000 high, and rebounded 40.1% to its 61.8% Fibonacci retracement level in just four months. The index proceeded to lose -49.7% in that year, and ultimately -80.8% at the 2002 bottom, all from the July reaction high.  I am not implying that the NASDAQ pattern in 2000 represents any market analog to today’s action. Barring some other unforeseen catastrophe, such as the Big One taking down California and decimating Silicon Valley, the market is not going to fall -80%

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I have heard comments from veteran technical analysts who have become bewildered by the market’s action. The word “unprecedented” is often used.

I beg to differ. The violence of the sell-off, and subsequent rebound is not an unprecedented event. Recall the NASDAQ top of 2000. The NASDAQ 100 fell -39.8% from its March 2000 high, and rebounded 40.1% to its 61.8% Fibonacci retracement level in just four months. The index proceeded to lose -49.7% in that year, and ultimately -80.8% at the 2002 bottom, all from the July reaction high.

Why this volatility isn’t unprecedented

I am not implying that the NASDAQ pattern in 2000 represents any market analog to today’s action. Barring some other unforeseen catastrophe, such as the Big One taking down California and decimating Silicon Valley, the market is not going to fall -80% from the reaction high.

In the past, I outlined my concerns about the stock market (see The 4 reasons why the market hasn’t seen its final lows). This week, I register additional concerns, mainly from a technical analysis perspective.

Repairing technical damage

My first concern is the level of technical damage in the March downdraft. Even if you are bullish, it is difficult to believe a market could rally back and shrug off that level of damage without at least some period of consolidation.

Technical analyst J.C. Parets recently showed numerous examples of technical patterns that needed repair. He compared the price of Carnival Cruise Lines (CCL)

Why this volatility isn’t unprecedented

…to Citigroup before and after the GFC.

Why this volatility isn’t unprecedented

He also highlighted the relative price action of technology stocks after the NASDAQ top.

Why this volatility isn’t unprecedented

There were other examples, but you get the idea. Even if you are bullish, the market needs time to heal. Stock prices were so stretched to the upside that technician Peter L.Brandt, another grizzled veteran, declared that he had sold all his equity holdings.

Frothy sentiment

Another concern I have is the frothy nature of sentiment. Greg Ip wrote a WSJ opinion piece which highlighted the lack of perception of the difference between lower tail-risk and the odds of a sustainable recovery:

There is another, less reassuring, explanation for the market’s rally: Investors are translating less-bad incremental news into a much faster economic rebound later this year, perhaps prematurely.

The lockdowns and the fiscal and monetary backstops have eliminated the worst-case scenarios “for hospitalizations, mortalities, and bankruptcy filings,” but not the baseline scenario “which involves a massive negative shock to national income,” said Mr. Thomas. This doesn’t seem consistent with S&P 500 index hovering just 15% below its pre-pandemic high.

Mark Hulbert also issued a similar warning when Goldman Sachs made a public U-Turn and turned bullish.

Consider the average recommended stock market exposure level among several dozen short-term stock market timers I monitor (as measured by the Hulbert Stock Newsletter Sentiment Index, or HSNSI). This average currently stands at 13.7%, which is more than 40 percentage points higher than where it stood just a few days ago, as you can see from the chart below.

That represents an unusually quick jumping onto the bullish bandwagon. The typical contrarian pattern at market bottoms is for rallies to be greeted by widespread skepticism. That’s not what we’re seeing now.

Why this volatility isn’t unprecedented

Incidentally, Mark Hulbert issued a second warning based on market seasonality. Historically, the six months beginning in May has been historically weak, and Hulbert observed that it is especially weak if the stock market in the previous six months was down.

Why this volatility isn’t unprecedented

Selling in May and going away is starting to sound good in 2020.

Waiting for the credit event

The Economist pointed out how fraud and credit event blow-ups occur in the wake of recessions:

Booms help fraudsters paper over cracks in their accounts, from fictitious investment returns to exaggerated sales. Slowdowns rip the covering off. As Baruch Lev, an accounting professor at New York University, puts it, “In good times everyone looks good, and the market punishes you harshly for not keeping up.” Many big book-cooking scandals of the past 20 years emerged in downturns. A decade before the crisis of 2007-09 the dotcom crash exposed accounting sins at Enron and WorldCom perpetrated in the go-go late 1990s. Both firms went bust soon after. As Warren Buffett, a revered investor, once put it: “You only find out who is swimming naked when the tide goes out.” This time, thanks to a pandemic, the water has whooshed away at record speed.

Setting aside any fraudulent activity, every recession has been followed by a credit event that has disrupted markets. The GFC was sparked by the failure of Bear Stearns, followed by Lehman Brothers. Investors were left holding the bag after the 2000 bear market when Enron, Worldcom, Adelphia, and others blew up. Regulators had to clean up the Savings & Loans crisis after the 1990 recession.

What credit event are we likely to see in 2020-2021? Bad debt provisions are already rising at the major US banks, but we haven’t seen any credit blowups yet. You know that things are bad when Verizon, a phone company, announced that it raised its Q1 bad debt expenses by $228 million.

Why this volatility isn’t unprecedented

What about the carnage in the oil market? Remember Amareth, the hedge fund that imploded when it tried to buy the front month in natural gas but couldn’t take delivery because of the lack of storage? Reuters reported that Singapore oil trader Hin Leong Trading owes $3.85 billion to banks after incurring $800 million in undisclosed losses. This blowup occurred before the front month WTI price fell into negative territory early last week.

Last week’s crash in oil prices may have created some financial damage. Interactive Brokers reported that it is making provisions for losses of $88 million from bad debt stemming from client accounts who were long the crude oil contract that crashed. Bloomberg reported that the Bank of China took a huge hit from a Chinese WTI ETF that it manages, It rolled its May positions forward on the Monday when the price went negative, which created large losses. How large? The market went into the open on Monday with an open interest of about 108,000 contracts, and Tuesday morning’s open interest was about 16,000. The market skidded by $50 per barrel on Monday, which translates to a loss of $4.6 billion for the closed contracts, not all of which are attributable to BoC. BoC has asked ETF holders to make good on the losses which drove the ETF’s NAV into negative territory. Given the highly leveraged and opaque nature of China’s financial system, we will never know the exact details of the losses, the risk is financial instability first shows up in China, and not within America’s shores.

Notwithstanding any oil related blowups, Mohamed El-Erian fretted in a CNBC interview about corporate and sovereign defaults. JC Penney and Neiman Marcus are already on the verge of seeking bankruptcy protection. The Gap announced last week that it was running low on cash, and it had stopped paying rent on stores it has shuttered. If the lockdown were to last until the end of May, other major retailers may have to follow suit. In that case, El-Erian worried that the government will have to make a major decision. Will it bail out all retailers, or will it have to pick winners and losers?

The signals from the credit market indicate a loss of risk appetite. High yield (junk) bonds have underperformed in the last two weeks despite the Fed’s intervention in the credit markets. The Fed can supply liquidity to the market to stabilize spreads and ensure the solvency of the financial system, but it cannot supply equity that was lost because of the crisis. In light of the well publicized difficulty of state finances, municipals have sagged as well.

So much for the bullish narrative of “the Fed is buying HYG”.

Why this volatility isn’t unprecedented

Stresses are also showing up in the offshore dollar market. The Fed has opened up USD swap lines with numerous new countries, in addition to supplying dollars through their existing swap agreements. This flood of dollar liquidity has been unable to stem greenback strength, and EM currency and bond market weakness. In particular, EM currency weakness will pressure countries with weak external balances, especially in the current precarious environment.

Why this volatility isn’t unprecedented

When does the next shoe in the credit drop in this recession, and is the market prepared for that event?

Narrow leadership

Another worrisome aspect of the market rebound is the narrowness of the market leadership. Remember Bob Farrell’s Rule #7: “Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names”.

The FANG+ and NASDAQ 100 stocks have been on a tear relative to the rest of the market this year.

Why this volatility isn’t unprecedented

SentimenTrader observed that growth stocks are becoming an extremely crowded trade, which usually does not resolve in a benign manner.

Why this volatility isn’t unprecedented

Here is what might derail the momentum of the FANG+ names. In particular, I am watching the Amazon, Google, and Microsoft earnings reports on their cloud services. While many investors have been focused on Amazon’s retail delivery services, which is a beneficiary of the work from home trend ruing the pandemic, their Amazon Web Service (AWS) is the company’s far higher margin business and AMZN’s jewel in the crown. The Information reported that cloud customers were asking for financial relief on their bills:

Public cloud providers like Amazon Web Services, Microsoft Azure and Google Cloud have had to cope with a surge in demand in recent weeks as huge numbers of people work from home. But the cloud providers are also facing requests from many customers for financial relief, while others are cutting their cloud spending.

So far, AWS has been the least willing to offer flexible terms on customer bills, according to numerous customers. That stands in contrast to Microsoft and Google which have shown some flexibility, partners say. How each of the cloud providers responds to customers asking for help has big implications, for both their near-term revenue and their long-term relationships with customers.

AWS has shown itself to be the least willing to give their customers breaks. (Reading between the lines, Lyft is the probably the reference ride sharing customer as it has guaranteed $80 million in payments to AWS.)

Inside AWS, salespeople have been asking managers how they shoudl best respond to requests for a break on payment from customers in travel, retail, real estate and ride ailing. A person who works at one of AWS’ largest customers said the company recently asked AWS for a financial break on its agreement, but AWS declined. An executive at an online real estate company said AWS pushed back on his company’s request for a break while another executive at a different company told The Infomation planned to ask AWS for a price reduction. The latter executive isn’t hopeful that AWS will grant the request, however, as it isn’t known for making pricing concessions.

By contrast, Microsoft has shown greater flexibility. While it is difficult to switch cloud providers during a period of stress as customers’ IT departments faces layoffs and staff reductions, AWS’ recalcitrant behavior risks alienating its client base and long-term relationships once the pandemic ends.

Microsoft has indicated to customers that it is willing to be flexible on pricing and contract terms if the Covid-19 crisis continues to keep the economy on hold, according to Adam Mansfield, director of services at UpperEdge, a firm that helps large companies negotiate contracts with cloud providers.

Customers in a wide range of industry segments have asked Microsoft for financial help since the beginning of March, including companies in consumer packaged goods, oil and gas, and retail, said Mansfield. Some have asked to defer payments for software they’ve used; others are asking for annual price reductions for software they’re planning to use in the future; and still others are asking to reduce the volume of users in agreements without a corresponding rise in per-user pricing.

Already, we are seeing how cloud services are evolving in the current environment from the IBM earnings report. While IBM is reporting strong cloud revenues, customers are delaying major development projects to conserve cash. Existing cloud revenue streams are likely to be untouched, but don’t expect much growth, and don’t be surprised at either delayed revenue recognition, or rising bad debts.

Amazon is scheduled to report earnings Thursday.

How a bear market bottoms

In conclusion, this is a recession. Recessionary bear markets take a long time to resolve, largely because of the technical and financial damage suffered in the downturn. As the macro and fundamental problems and uncertainties resolve themselves over the course of the downturn, that’s the mechanism how the stock market returns to retest its initial lows after the first reflex rally.

Consider the problem of reopening the economy. Selected European countries and US states have begun to relax their stay-at-home edicts and reopen their economies. Based on the first in, first out principle, we can see how the Chinese economy has fared in their efforts to reopen. Manufacturing and industrial activity is almost fully back to normal, though the sector is burdened with a lack of foreign demand. However, the consumer and services sector has recovered far more slowly.

Why this volatility isn’t unprecedented

Let us assume for the moment that the efforts to reopen the US economy is successful. The American economy is mainly consumption and services driven. If the consumer is still weak in China, how weak will it be in America, and what will be the effects on economic growth?

Now consider all these markets from a technical perspective. The S&P 500 and DJIA have violated uptrend lines, indicating bullish exhaustion as they approached their 50 dma.

Why this volatility isn’t unprecedented

Similar technical patterns can be seen in the Shanghai Composite, and the stock indices of China’s major Asian trading partners.

Why this volatility isn’t unprecedented

Don’t forget the DAX. Germany is taking small steps to reopening its economy.

Why this volatility isn’t unprecedented

Are the global markets trying to tell us something? I interpret these technical patterns as a setup for a retest of the March lows at some point in the future. Depending on the nature of the fundamental and financial damage, the retest of the lows may not necessarily be successful.

This is the process of how a bear market bottoms. We have only undergone the first stage of the decline.

Stay tuned.

About Cam Hui
Cam Hui
Cam Hui has been professionally involved in the financial markets since 1985 in a variety of roles, both as an equity portfolio manager and as a sell-side analyst. He graduated with a degree in Computer Science from the University of British Columbia in 1980 and obtained his CFA Charter in 1989. He is left & right brained modeler of quantitative investment systems. Blogs at Humble Student of the Markets.

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