A succinct summary of key insights from recent subscription newsletters.

Thoughts on the market environment

From a relentless march to new highs to an unprecedented crash and now a generational rally – during the first four months of the year the stock market certainly showed us everything it has got. In the face of high uncertainty, sheltering at home, with the world economy in a shutdown as we have never experienced, making good investment decisions is difficult.

Here a systematic strategy with clear rules really shows what it is worth. The Meta Strategy´s definition of the market environment is crystal clear, even if the future is anything but. Stocks are currently in a highly volatile bear market. We are still in a long term down-trend and an environment of elevated volatility.

The S&P 500 rally stalls below its long-term moving average (275-day SMA) while the VIX is still far above its mean – even after falling significantly from March peaks. 

My basic premise is that the market regime is “sticky” and will likely stay in its current condition for some time until a new environment is indicated by the strategy. Investing accordingly has the highest probabilities for success – albeit no guarantees.

An epic battle: dire economic conditions versus enormous stimulus

We are beginning to see a shift in perception – whereas the recovery from the pandemic was the primary narrative throughout April, the perception and news flow begins to switch to the dire economic conditions caused by the shutdown. This could very well lead to another long move down for equities, but nobody can accurately forecast developments at the moment and surprising news (be they positive or negative) can almost be counted on.

As was widely expected current economic data shows a deterioration of historic proportions across the bank. Because the economic shock was so unexpected, there was hardly any fundamental advance warning going into the stock market crash – leading economic indicators can only signal deteriorating conditions not a tectonic shift in economic activity caused by an exogenous shock. 

Unemployment data is showing spikes which surpass previous peaks by orders of magnitude, the majority of retail sectors have simply ground to a complete halt while financial conditions tighten. Numbers for housing, that have been a bulwark during the bull market, are falling off a cliff as are the numbers for industrial production and manufacturing. Consequently GDP is dropping like a stone.

The unemployment rate spikes while retail sales collapse – both far surpassing the worst period of the Great Financial Crisis.

It is hard to imagine that this can reverse as quickly as it appeared and many market commentators are dumbfounded by the recent strength in equities. Enormous amounts of liquidity through monetary easing and fiscal stimulus by central banks and governments around the globe are the main driver behind this rally. 

We are now witnessing an epic battle between a historic drop in economic activity counteracted by unprecedented stimulus: it is is an irresistible force meeting an immovable object. Who the winner is going to be is the key question for the coming months – we can expect some back-and-forth as one side or the other is gaining the upper hand as the fight progresses.

Lessons learned from the Coronavirus Crisis

These are the key take-aways of investing and trading through the last couple of weeks for me – an extreme environment always accelerates the learning curve and risk awareness:

Process over outcome. It makes little sense to bet on historically unprecedented market moves as these are by definition very rare. Should they occur large drawdowns are to be expected and must be tolerated in order to be able to take advantage of the long-term return of risky assets like stocks. Risk and return will always be closely connected and there is no holy grail strategy that can severe that relationship. 

Awareness of the maximum risk one is exposed to (for example by analyzing a strategy´s past drawdowns) is essential. It certainly helps when a strategy has a defined exit point (as the Meta Strategy does in the form of a stop loss, that triggers should things go off the rails suddenly), because it will reduce uncertainty and enable us to keep track of the market with a clear mind.

Behavioral biases are real. The mental flexibility to react quickly and decisively to a change in the market environment is very difficult to achieve even with a systematic ruleset on hand. Good performance tends to lead to overconfidence and a lack of respect for key signals when the environment changes all of a sudden.

The volatility market regime is a great predictor for trading returns. Once again the really difficult times came after the VIX futures term structure signaled elevated danger. Looking back over the years it would have always paid off to adjust decisively to such signs of a key regime change and reduce position sizes down as well as assign higher probabilities to epic market swings. Even pausing all trading activity for a couple of months would be a sensible decision.

Quick list of current key insights going forward

• Current Market Environment: Bear Market and High Volatility Regime
• Basic Premise: Market Environments are sticky – trading with the trend will be profitable over the long term
• Uncertainty: High Volatility Regimes are hard to trade and the focus is on preserving capital for the next bull market
• Big Picture: two major scenarios are both likely
  • 1) Bear Case: The coronavirus shock speeds up the usually drawn out top of a long bull market and this crash cascades into a longer economic downturn & severe bear market of -40% to -60%
  • 2) Bull Case: The coronavirus impact is strong, but temporary. Enormous stimulus acts like rocket fuel to propel economic growth to bounce back quickly 

Main market drivers

• Central Banks vs Recession = extraordinarily strong stimulus confronts the biggest, sharpest GDP decline in history: This is the irresistible force meeting the immovable object.
• Coronavirus: stopped the real world economy
  • how much irreparable harm will be caused, how much is temporary slowdown in solid economic environment that can be saved by stimulus?
  • Flattening curves now visible worldwide and economies reopen slowly = reason for initial relief rally, but all good news now priced in?
  • Key question: economic slowdown vs. fiscal stimulus > what will be stronger?
• Uncertainty & lack of historic precedents makes forecasts extremely difficult
• Exogenous Shock Bear Markets are short (avg 15 months) and shallow (avg 30% decline) historically 
• Bear Market may morph into longer recessionary bear market – pandemic may trigger overdue economic decline

Live and invest safely!

David

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