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Hello. Yesterday morning’s letter opined that ‘It’s a scary moment, but it doesn’t look like the edge of an abyss’. Well, Ethan and I felt like morons at lunchtime and geniuses at teatime. We had insisted that the extremes of selling were confined to the riskiest segments of the market; that the economic backdrop has remained strong and could improve if the virus loosens its grip; and that the Fed could still move forward at a deliberate pace, rather than applying the brakes. But as the S&P 500 fell 4% and the selloff hit stocks of all kinds, we began to wonder if we had been paying attention to the right things.

At the close, the market was in the green. What is going on? Email us your theories: [email protected] and [email protected]

Markets are quieter than they appear

Of course, we cannot make sense of extreme intraday volatility because it is not at all necessary to make sense. But there is something to be said for the larger context and – without assuming what today will bring – helps explain why the market caught a bid yesterday afternoon.

A key piece of the backdrop is the calm that prevailed in bond markets even as fear gripped equities. Here’s the S&P’s selloff over the past month, against an index of the riskiest corporate bond spreads. As the selloff gathered pace, the yield spread for risky bonds over treasuries widened moderately – ending roughly where it was a month ago.

I asked Marty Fridson of Lehmann Livian Fridson about the relative calm of junk bonds. He said:

This seems to suggest that the inflation premium is rising and higher discount rates are being applied [to stocks]. That’s different from saying the economy is collapsing. There doesn’t seem to be concern about earnings, but rather valuations. It is not an economic issue that would cause [bonds’] rising default premium. . . there is always the possibility of a Fed error [hitting the economy] but that’s not where the market is

Moving on to another corner of the market, I asked Jenn Thomas of Loomis Sayles, who covers asset-backed securities, if this market had felt any repercussions from selling stocks.

ABS didn’t miss a beat, she said. She describes the pricing of consumer ABS – backed by car loans, credit card receivables, personal loans, and more. – as stable to the point of ranging in recent weeks. Three new issues (subprime auto, prime auto and personal loans) were priced yesterday as the stock market was on a rollercoaster ride, and all were oversubscribed. The $40 million triple B tranche of the consumer loan ABS, yielding 4.4%, was oversubscribed by a factor of nearly five. “The demand is so heavy,” she said.

Thomas noted that after a long hiatus created by stimulus checks and additional unemployment benefits, “typical subprime behavior” is starting to return to lower-rated stocks. A modest increase occurred in the early stages of delinquency. But this does not affect investor demand.

Commodities are also indifferent. Copper and aluminum have been trading roughly sideways for weeks. Gold could even benefit from the crypto selloff (see below) as investors wanting cover look elsewhere. Brent crude fell around 2% on some Monday turmoil, but David Martin, head of commodities strategy at BNP Paribas, offered this bullish reading:

The outperformance of Brent relative to other markets, for example European equities, speaks to the fundamental support offered by the tight physical market conditions at the moment. Arguably, the fact that Brent spreads have held up so well, in the face of a 2% drop in the fixed price, signals continued strength in the prompt [ie, short-term] Marlet.

Finally, the options market is not expressing any particular panic either. We asked Benn Eifert, who runs QVR Advisors, a volatility and derivatives hedge fund, what the equity derivatives markets tell us about the cash equity market. We talked before the market rebounded at midday yesterday. He said:

In the last weeks of December you had a lot of rapid institutional deleveraging [options positions], which greatly reduces net leverage and gross leverage as well. There was a lot of buying of put options at the end of the year [for downside protection].

When we arrive in January, [stocks] sell, with the technology and software that sells the most, there has not been much response [in the options market] because people weren’t above their skis. People had already de-risked…

Now we’ve had a big enough spike to bottom out, and options liquidity is doing weird things in markets like this…but it’s not something that’s driven by an individual [big trade unwinding].

It’s really retail that’s super long, and all the data shows that retail is trying to buy the dip. It’s like you won’t see any fireworks, because you don’t have people getting liquidated from huge positions. Fast money institutions are usually the cause of big crashes.

The sensible positioning of big institutional capital doesn’t mean the market can’t fall much slower, Eifert pointed out. It just means that a wild self-reinforcing selling pattern is not likely.

In summary, then, it still looks like we’re dealing with a relatively contained sell-off in equities, rather than a general flight of risk. Investors act nervously, but not indiscriminately. And within equities – to overgeneralize a bit – the sell-off is focused on the kinds of things that have done well for much of the past decade, and particularly well over the past two years. It’s not just speculative tech stocks. Indeed, the pattern may be best visible in the performance of US equities (the big winners of the past 10 years) relative to equities in the rest of the world over the past three months. Chart from Refinitiv:

Probably the most extreme example of recent winners coming to their senses is crypto, where the total market capitalization has been halved in just two months. Movements in bitcoin — one of the least volatile cryptocurrencies in recent days — have increasingly followed stocks, peaking in bitcoin-S&P correlation on Monday as bearish buyers rushed in (data from Koyfin via CoinDesk):

Evidence of a lasting relationship does not exist here. S&P rallies do not consistently accompany bitcoin surges. But since the pandemic, it does seem like bitcoin speculators are inclined to sell when stocks get ugly. But bitcoin has already rebounded from deep lows. (Armstrong and Wu)

A good read

Gideon Rachman on the “navel-gazing” of Western Europe in the face of Russian threats.

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