The Hitch Hiker’s Guide to the Volatility
October 21, 2018
-- Words Inscribed in Friendly Letters on the Fictional Cover of “Hitchhiker’s Guide to the Galaxy”
“No regrets, Coyote, I’ll just get out up a-ways,
You just picked up a hitcher, prisoner of the white lines on the freeway”
-- Joni Mitchell
Nope; Don’t Panic. I’m not. Panicking that is. It was a difficult week, and it didn’t end particularly well for me. As prophesied in these pages, our equity indices did begin the sequence by recapturing some lost ground from the previous 5-day rout, but they couldn’t hold their recaptured ground, and, by Friday’s close, the Gallant 500 had managed to add a microscopic half an index point (1.8 skinny basis points) onto its valuation tally. OK; fair enough, but then, Friday afternoon, I paid a visit to an old comrade of mine – perhaps the best macro trader I ever had the pleasure for whom to serve as risk manager, and he did not share glad tidings. Inflation, though latent, is on the visible horizon, rates must go up, and this will put us into recession. Extrapolating an attendant ~30% hit to earnings, along with an approximate 20% multiple compression, he’s looking at a potential stature slicing of the SPX by nearly 50%. Overall, though, the conversation was pleasant enough, and ended on an encouraging note: the debacle won’t hit right away, and there may be some compelling opportunities in regions such as Europe. Or so he told me.
I managed to gather myself, but it wasn’t long after my equanimity returned when, Friday night, a guy I have known for even longer predicted that Monday – this Monday – will be a Black Monday. He and I endured the 1987 version of this together, pulling our traders out of the quaint but anachronistic 30-Year Bond and S&P 500 pits-- so as to avoid incremental gratuitous violence to the under-capitalized floor trading group that we managed at that time. And it worked. The group lived to fight another day, and, somehow, more than three decades later, is still at the game (albeit in modified form).
So I got to thinking: is there a crash on the horizon? Well, I highly doubt it and told both my friends so. But crashes, like volcano eruptions, black holes and other singularities, are part and parcel of life in this here galaxy, so, at least on paper, it pays to be prepared.
And lord knows that if a crash were indeed to transpire, we’d have no shortage of rear-view mirror root causes upon which to cast blame. That great engine of domestic and commercial prosperity – the American Housing Market – is showing multiple signs of being gassed and needing a blow. Economists, though, are at a loss to explain why this is happening. And I am particularly skeptical whenever I read tortured analyses that include both the demand suppressing forces of rising mortgage rates, and a shortage of inventory. Guys. Please. It can’t be both. While economic forecasting may be the most dubious intellectual discipline on the planet, we have it on pretty good evidence that price drops tend to derive from a decrease in demand, an increase in supply, or some combination of the two. My guess is that the Housing Market is probably a bit overvalued (which will happen after an 8-year run), and that the higher mortgage costs are not helping. But I promise you this: if the buyers were there at appropriate prices, sellers would indeed materialize – in force.
But there’s ample reason for concern across the macro galaxy, and they extend beyond the narrow part that our humble homes comprise. The Brits seem really confused on this whole Brexit thing, and if they’re perplexed, where does that put the rest of us? Italy continues its shenanigans, so much so that the demonstrated-to-be-infallible credit analysts at Moody’s Investor Services cut the country’s credit rating to Baa3 – one level above junk. We know, but hardly need to inventory, the problems plaguing the Chinese economy. It’s equity indices, for what it’s worth, are now in the grizzly realms of a > 35% correction. Trade wars rage. The redoubtable Ned Davis’s economic models now indicate a 92.7% probability of a global recession:
But let’s return to the land of Amber Grain Waves, shall we? Well, here, a number of factors do concern me, and one that has drawn the atttention of the risk-taking classes is the sustained rise in 3-month LIBOR, now clocking in at levels last seen in 2008:
Sharp-eyed observers will note that the last time this borrowing cost benchmark hit the lofty level of 2.469% was Q4 of 2008, but at that point, it was coming careening down and would soon reach the economic equivalent of 0.000%. It says here that high and rising interest rate glide paths are another matter entirely, and not a particularly pleasant one at that.
But while short-term rates continue their heavenward climb, the long end of the U.S. curve remains fairly stationary, thereby proving my macro mate’s point about cross asset correlations (see Paragraph 1, above).
As a public service, and by way of putting this in perspective, I offer the following visual tidbit that provides at least anecdotal evidence of what happens when free financing disappears, and borrows must pay a cost to fund their dreams and aspirations:
For the uninitiated, the blue line is a mash up of the costs associated with debt-based finance (credit spreads, interest rates, FX impacts), as brought to us by those well-endowed purveyors of truth at Goldman Sachs. The white line is the SPX. Goldman too is predicting a slowdown. Or was that Morgan Stanley?
No, now I remember: it was Jamie Dimon over at JPM. But whether he’s right or wrong, we can be fairly certain that he’s not panicking.
In addition, we do have a bit of a political mess on our hands, with the infantile mud-slinging reaching, nearly every day, a new, improbable high, and an important election now a short two weeks away. Our President is trading zingers with pole dancers, and, while 1,000 people a week are dying of opioid overdoses, the cameras are trained on menacing looking caravans heading northward from Guatemala. Public attention is also transfixed on the murder of a journalist by a country that has used this as a form of governance, like virtually every other nation on earth, since time immemorial. It is the biggest crisis between the U.S. and the House of Saud since the OPEC Oil Embargo, but it I think that like the Las Vegas massacre and so many other tragedies, it will pass into obscurity very quickly. Unless it escalates under the Arch-Duke Franz Ferdinand paradigm, at which point I’ll be forced to reassess its implications.
In the meanwhile, on the other side, the once and likely future Speaker of the House warned of collateral damage to anyone in dissent of the righteous dreams that fit her side gig of being married to a billionaire San Francisco real estate developer. Her party’s most recent standard bearer leaped from grandstand to spotlight with her observation that civility can be contemplated by her minions only after political victory has been secured.
It’s no wonder that everyone in investment land has a case of the willies, but I suggest that a better course is to continue operating like you would if the world weren’t showing signs of madness. We remain at the lower end of the range which I described last week as offering favorable entry points, and I’ve really no choice but to double down on this call. The names I quoted as being “cheap” are still on their heels. None have reported yet, but their earnings announcements are just around the corner. There’s plenty of room for upside in those securities, and if they do rally, then they’ll take a lot of other stocks along with them for the ride. One way or another, earnings growth remains robust, real rates low, and, while the Atlanta Fed’s GDP Now tracker has slipped to a beggarly 3.9% for Q3, that wouldn’t be such a bad print, now, would it? We’ll find out on Friday, when the introductory estimate is actually released.
None of this ensures that we won’t be making new lows over the next little while, and for all I know, my pit manager buddy may be right. Monday may bring Armageddon, but I kind of doubt it. Further, if the market does crash, and this crash is not caused by a military coup led by the XX cabal of Pelosi/Clinton and Warren, then anyone with any cash left should probably load the boat.
One way or another, the volatility spike is likely to continue, and I reckon we’ll have to live with this. Again, I don’t see a breakout from SPX 2750-2900 under any circumstances, but odds on likelihood is that we’ll bounce around between these levels pretty aggressively over the next couple of weeks.
And my best advice, in terms of volatility management, is that contained in the Hitchhiker Book within the Hitchhiker Book: Don’t Panic. Keep doing what you’re doing; cut risk if you must but preserve core investment themes. But in the interest of full disclosure I must inform you that I have never actually read “The Hitchhiker’s Guide to the Galaxy”. I started it a couple of times, but it never took hold. I’m not proud of this, and as long as I’m unburdening myself, I should inform you that the same goes for “Zen and the Art of Motorcycle Maintenance” and (perhaps most shameful of all) Kerouac’s “On The Road”.
I am, however, intimately familiar with Joni Mitchell’s “Coyote”, and can more confidently assert that yes, we’re all hitchers, each of us is a prisoner of the white lines on the freeway. For now, our best moves involve staying within those painted path markers. Those that do are likely to come out of this not much worse off for their troubles.