Are we nearly there yet?

Like the child in the back of the car asking are we nearly there yet about a million times, the question on everyone’s lips is just that. Is it over now? Can I open my eyes again? Can I finally check my brokerage account for the first time since February?

Well one way of framing that question is to compare now to 2008 (what else?).

Because 2008 was bad, right? I mean really really really bad. The housing market, and banking system both collapsed. I mean seriously, it’s genuinely hard to imagine two more fundamental things to our modern societies. And not one but both of those things collapsed under their own failings, simultaneously. Can the corona-crash really be worse than that!?

Can I put together an argument forward that what’s happening now is worse than 2008?

Because we’re over halfway there in terms of markets, financial conditions and way further in terms of job losses (3.3 million jobs lost in a single week in the US).

In Monopoly, you’ve got a bank, and you’ve got property.

Why? Because they’re the two most fundamental things in our economy.

Houses and banks both went wrong in 2008. Literally, could anything be more fundamental and damaging than that?

Everyone is fearing the absolute worst right now. There are cataclysmic news reports, record-breaking unemployment numbers, and just the generally apocalyptic sight of shuttered shops and long queues outside supermarkets.

As markets muddle their way downward (unless this week’s bounce already marks the bottom which is theoretically possible, though unlikely), I’m wondering whether this really is worse than 2008, when our banks went bust and housing markets tanked.

To start – look at this interesting chart. Take a few minutes over it I’d say, there’s a lot in there. Do you know about each bear market listed? They’re all worth reading about to help shed light on our current situation, and how it ranks.


Figure 5: Bear markets can either be Structural, Cyclical or Event Driven. Structural bear markets caused by financial bubbles and imbalances last the longest and cause the greatest wealth destruction. Event Driven bear markets are the shortest.

A first level analysis would be that this is clearly event driven, so maybe that’s that? One month, 35%, and done. And that is certainly possible. Not sure what the odds are, maybe… 25%?

However, a second level analysis might say well hey, what if it’s possible that this is actually both? Or even, all three at once?

Event driven – confirmed. Cyclical – sure, we just had the longest up cycle ever, 11 years. So, we were due a cyclical turndown. That’s two. Structural? Well here it gets a bit more complicated. And this is the big one, and as you can see, it’s the structural crashes that are the deepest and longest.

One structure that could be unravelling is the risk-parity fund (60/40 stocks/bonds).

I wrote early last year about the work of Chris Cole and Artemis, his hedge fund.

They were absolutely fanatic about the threat of the “short-volatility trade” – where firms bet on volatility staying low or going lower. You can do this directly in the options market, or implicitly through asset allocation, because many risk-parity funds use volatility as a target to dictate how much “risk” they should take.

As volatility goes lower, they allocate more to “riskier” equities, because broader market risk, using volatility as a measure (bad idea), was lower.

As a result, they are all heavily weighted towards equities, and reliant on the idea that equities and bonds are anti-correlated, that is to say bonds go up when stocks go down.

The first thing means that when volatility rises (and boy did it rise in the last month, to levels higher than in 2008), all these risk-parity funds have to sell equities. All at the same time. Forced simultaneous selling? Can’t be good…

The second assumption is that stocks and bonds are anti-correlated, and that isn’t necessarily true either. It’s been true for a bit, but if you take a longer-term view, of 100+ years for example, then it loses its consistency.

The amount of money both explicitly and implicitly “short” volatility goes into the trillions. So that is one major structural issue that is unwinding.

Another case to make is that the crash is falling from higher valuations than in 2008, as shown by this chart of the US market cap to GDP.


But how about this from US jobless claims – 3.3. million lost their jobs in the US in a single week. It’s a number so big it’s hard to comprehend. But how about this chart, from 1970, for context.


The markets went up on the news, but then again, markets price the difference between expectations and reality – maybe people thought it was going to be higher.

Or perhaps there will be a delayed reaction, just as there was with the Federal Reserve’s rate cut and infinite QE announcements, which both took 24 hours to sink in.

Other structural issues include inflation. I spoke about this on Wednesday (you can find the article here), and there is a strong case for saying that once this obviously deflationary year is over, the fiscal stimulus from governments is so large and directed for once at the real economy – people and businesses – that an end to the 30-year deflation regime may be much closer than almost everyone thinks.

Because higher inflation needs higher interest rates to dampen it (or at least, that is the received wisdom…), increasing inflation means a departure from our lovely low rate environment, which is so good for stocks.

That would certainly make now worse than 2008, because it would usher in not a crash, a bottoming and a steady recovery but a more drawn out decline in the value of stocks; like in 1929 when a one-month 34% crash was followed by a four-year bear market, eventually bottoming out around 90% down from its peak.

That’s the deepest and scariest possible reality.

And this chart from one of my absolute favourite analysts, Tavi Costa at Crescat Capital, does little to assuage my fears.

Source: Crescat Capital, Twitter

(By the way, read its quarterly blog posts, they are fantastic and it has predicted and done brilliantly from this current crisis.)

So, there’s a valuation anomaly, a changing of the inflation guard, and a global short volatility trade that have the potential to make this much, much worse.

Now, looking again at that first chart comparing all the bear markets, it’s very reasonable to make a few comments.

Firstly, to be as bad as 1929, or just worse than 2008, this has to be the worst year in 90-odd years.

That is statistically unlikely.

However, that doesn’t mean it’s impossible.

For my money, the monetary and fiscal policies available are incomparable to the 1930s, and our societies are much more capable of turning things round quickly than we were back then.

Global cooperation, technology, better healthcare… capitalism has improved things beyond belief.

Also, I think that psychologically, the markets always go up in the long run view might be so entrenched in the average investor’s mind that it benefits from George Soros’ theory of reflexivity, where a view on the markets isn’t a passive, irrelevant thing, because it leads to actions which help to confirm that view.

So that average investor who believes in the long run and buying the dip will act on that belief, thereby supporting the stockmarkets.

Factor in unlimited QE, fiscal stimulus and an energetic global response to the crisis, and I am not convinced that this will be anything like the Great Depression of 1929.

2008 is more achievable in terms of crisis levels. The economy has ground to a halt faster, and markets have fallen faster than they did then.

This is a crisis-driven bear market so far, short and sharp, but that by no means precludes a second, separate bear market that is more traditional – based on an economic downturn and a slow increase in pessimism regarding the short-term trajectory for companies, countries and the markets.

As always, the thing to do is to avoid picking one forecast, and investing accordingly. Rather, you want to weigh up the different options and realise that they are all possible, as well as a few that no one has even thought of yet.

Can you ascribe odds to them? For me I’d say this has a one in five chance of being over already, a 50% chance of getting worse but not as bad as 2008, a 20% chance of being worse than 2008, and l will give a 5% chance that it’s as bad as 1929, with 5% spare for unimaginable things, like new all-time highs before the end of the month, and stockmarkets shutting down.

My odds hardly even merit BOTE (back of the envelope) status. They’re mainly to suggest that you think about all possible eventualities, and try and calmly and fairly ascribe likelihoods to them all, rather than buying into just one. Single factor analysis, or picking one forecast and ignoring the rest.

Maybe you disagree with me. Maybe you are more pessimistic. Maybe you’re worried about the bankruptcies to come, the corporate bond downgrades sending the record pile of investment-grade bonds into the uninvestible “junk” category. Or perhaps, you think that the psychology has turned, and people are now selling the rally rather than buying the dip.

If so, then I have something for you.

And if you are more optimistic like me, but just don’t want to be too confident about it, then I have something for you too.

It’s a special report by Nick Hubble, a friend who I’ve mentioned in this letter before. Unless you are sure that this is over, and we are heading back to infinity and beyond, then Nick’s special report on six assets to own to get you through a financial crisis is well worth a read. I can’t put it more simply than that.

You can access it by clicking this link.

In the UK, we know the weather can change quickly. We’re good at taking an extra layer, even when the sun is shining. The current rally may have calmed the nerves somewhat, but that rain jacket may yet come in use.

All the best,

Kit Winder
Investment Research Analyst, UK Uncensored

PS For those of you who have been enjoying these letters, I am also on twitter on @WinderKit.

1 Comment
  1. […] To illustrate this idea, take a look at this chart of the CBOE’s VIX index, which measures implied volatility (the chart above shows what actual volatility has been, the VIX uses options to show what the markets think it will be.) This time around, it topped 2008 levels, suggesting that the markets are slightly more pessimistic than me, as per my article on Friday. […]

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