JUNE 2020 MARKET UPDATE

I like to think (and
the sooner the better!)
of a cybernetic meadow
where mammals and computers
live together in mutually
programming harmony
like pure water
touching clear sky.

I like to think
(right now, please!)
of a cybernetic forest
filled with pines and electronics
where deer stroll peacefully
past computers
as if they were flowers
with spinning blossoms.

I like to think
(it has to be!)
of a cybernetic ecology
where we are free of our labors
and joined back to nature,
returned to our mammal
brothers and sisters,
and all watched over
by machines of loving grace.

All Watched Over By Machines Of Loving Grace
Richard Brautigan, 1967

Our analysis of the global rebound in asset prices

Stock markets are febrile, often behaving like animated teenagers with soaring and then plummeting emotions. The dotcom boom was a perfect example, where markets seemed to veer from “this internet thing will change the world and we must jump on board or be left behind” to “these companies make no money and I’ve just noticed that they have no balance sheet – run for the hills”. However this theme is usually expressed over years not months. The performance of stock markets this year has seen these animated teenagers behaving as if they have been given copious narcotics and a free pass.

From the February high US stock markets underwent the fastest ever bear market, declining by 34%. In the UK it took just 14 trading days for the FTSE100 to decline by 30%.

There were obvious reasons for this. The pandemic was one and governments’ response to it another. Huge uncertainty, ruined profits, corporate failure and depression level unemployment all provided a cogent reason for this rapid repricing of assets.

However, in the following 50 days the US stock market underwent the largest rally in its history, rising nearly 40%. The NASDAQ, where most of the technology companies are listed, has not just recovered, it is trading at an all-time high.

You will note that the lockdown has not yet ended and indeed additional troubles have been added to the list of things to worry about.

So the two interesting questions are: what has caused this and is this response justified?

Why the bounce?

Firstly we should establish that it is impossible to be certain. There are a multiplicity of reasons for the bounce, some of them are reflexive (like a feedback loop), and the best we can do is to use our judgement and experience to try and process the limited data into a rough order.

The market had obviously panicked – there were signals from asset price movements that suggested market participants and hedge funds were dumping assets and running for cover. We called the bottom on the 18th May when the FTSE100 closed at 5081, that is we went on public record to say that in our estimation stock markets were likely to rally from this point on. It was bold considering the speed and size of the fall, but we were right.

We have a better understanding of the pandemic now and governments have been able to “flatten the curve” so some of the concerns at the time have diminished. Investors also took the view that even if you ignore 2020 and factor in a mediocre 2021 then stock prices could still be considered to have overreacted. In a macro-sense we were heading in the right direction even if the pace and end destination remained a little foggy.

As such there were some fundamental justifications for a modest bounce and recovery. However, the scale and speed of the rise implied that there were more powerful agents at play. Over the last week it has been common to see the bounce described as the “Robinhood rally”. Robinhood is a popular free trading app in the US and there has been a surge in retail investors using it. Supporting this claim is that there has been a sharp decline in retail spending, with credit card usage down, and with $1,200 “stimulus checks” in their pockets and an absence of gambling opportunities as sporting events have ceased, gambling on stocks is now en vogue.

It is also evident in some strange trading patterns. You will no doubt know the car rental firm Hertz. On May 22nd it announced it had entered chapter 11 bankruptcy proceedings. This was not a surprise. It had $19bn of debt and no revenues to speak of.  The share price had fallen from $20 to $2.8 as the pandemic wrecked its business and it gradually succumbed to the inevitable. After the announcement the stock slumped to $0.56 as trading in it dried up. It may seem strange that it didn’t go to $0, but in practice there are not many buyers for equity that is, in principle, worthless – if there is no market the share price can get stuck at the last price the stock was traded.

What was indeed surprising is that the share price did not stick at $0.56, it rose to nearly 10x that. It now has a market capitalisation of over $400m and has announced plans to raise another $500m of equity as the company tries to take advantage of the rise in the share price. This is bonkers. Even with the extra $500m its slide into bankruptcy is almost certain. Here is the relevant risk factor disclosed by the company:

“Although we cannot predict how our common stock will be treated under a plan, we expect that common stock holders would not receive a recovery through any plan unless the holders of more senior claims and interests, such as secured and unsecured indebtedness (which is currently trading at a significant discount), are paid in full, which would require a significant and rapid and currently unanticipated improvement in business conditions to pre-COVID-19 or close to pre-COVID-19 levels. We also expect our stockholders’ equity to decrease as we use cash on hand to support our operations in bankruptcy. Consequently, there is a significant risk that the holders of our common stock, including purchasers in this offering, will receive no recovery under the Chapter 11 Cases and that our common stock will be worthless”.  

If you invest in shares with risk warnings of this nature you absolutely are not doing so on fundamental grounds. You are only doing so in the hope that the share price will go higher.

It’s not just Hertz. JC Penney, the bankrupt US department store company filed for chapter 11 on May 15th. Its shares were up nearly 200% last week. Other bankrupt companies are experiencing the same dynamic in our own little stock market pandemic. This is not an entirely new phenomenon. Many recoveries from bear markets have periods that are known as the “dash for trash”, where the most indebted companies outperform the broader market as people upgrade their expectations of the company’s survival. We last had one in April/May 2009 when we emerged from the financial crisis.

Now there are always naive investors. The owners of Wirecard shares certainly have an interesting approach to analysis. The German payments processor was the subject of a withering examination of its accounting practices by the FT in October 2019. These were not rebutted by the company and after intense pressure KPMG were recruited to undertake a review. This led to a second wider review, which led to the discovery, yesterday, of a €1.9bn in missing cash. Wirecard was valued at €24bn in 2018, but even as it battled public allegations of fraud, forgery and opaque business practices, it still had committed investors and champions. Even in April it was worth €16bn, though it has fallen by 85% once this black hole was announced.

In the case of the US zombie companies coming back to life, there is a demonstrable impact in trading from the “Robinhood trade” but this narrative fails to reflect the full story. Analysis has shown that there is actually a negative correlation between the number of Robinhood users holding a stock and the price returns of it. But this is to misunderstand the role of algorithmic and quantitative investing in markets. Robinhood traders do not need to add volume, they just need to provide direction. If they push up the share price of one of these companies at the start, then it flags signals in momentum funds (momentum funds don’t care what they buy, only that in the last few weeks/months the company’s share price has risen – a rising momentum is a strong signal that a company’s shares will continue to rise). Once these institutions start to buy you get reflexivity. The share price rises which means the momentum signal is stronger, attracting in more momentum funds in a growing feedback loop.

The overwhelming majority of trades on global stock markets are now undertaken without human intervention; computers executing trades mostly innocently (an ETF or tracker fund simply buying more shares with cash invested for example), and mostly competently (examples where momentum funds egg each other on are still rare).

The rally in global stock markets has almost certainly been driven by algorithmic trading from institutional investors. Their power dwarves the retail Robinhood trading hero. The underlying calculation is that with interest rates at zero and set for negative, and with aggressive bond buying by the Federal Reserve flushing the system with liquidity, then this excess cash simply must be invested in equities – where else can it go?

As COVID-19 led to lockdown and stock markets fell we were buyers of equities. Our confidence diminished as this steep rally grew and we recently reduced our equity exposure to deepen our reserves of cash. One day people will again look at fundamentals and will discover nuance and ambiguity. Today it appears stock markets, and indeed politics, possess a more binary, black and white, view of the world.

A modification from “panic” levels was certainly justified but we believe skipping straight through “sensible” to get to “euphoric” is not. It may be that markets are driven higher still but we believe it is prudent to exercise caution when there remains high levels of uncertainty and a very deep recession to come.

The computers driving this rally are not modelled on “Mother” the malign computer from Alien, or Hal 9000, the malfunctioning computer from 2001: A Space Odyssey, but they are capable of systemic and reflexive mistakes.

The machines of loving grace driving stock markets are not to be trusted.