I hope you are all staying safe at home.
I want to consider:
- how safe are markets?
- Is this yet another short term dip to buy?
- A recession which we ride out with buying opportunities?
- Or the early stages of a major crisis like 2008?
Life cycle of a major crisis – 2008
- Complacency and denial. (up to January 2008)
- Awareness grows. Faith in policy makers is strong, even though the policy makers do not yet understand they are not in control. Markets believe it will be ok – e.g. positive reaction to Bear Sterns bail out. (1st half of 2008)
- Huge panic as it becomes clear that policy makers have no control (Lehman)
- Policy makers start to get a grip, but markets no longer believe them (late 08 early 09)
- Markets start to rise, albeit with a lag (Q2 2009)
Where are we in 2020?
Complacency and denial have been overwhelming until very recently.
Last 2 weeks have seen some growth in awareness (Stage 2) but there remains a lot of confidence that issues can be contained. For the current market pricing to be correct we are either:
- Correctly pricing a normal recession
- Having a severe risk off event
Note that we are not pricing BOTH. Perhaps we are not far from correct pricing for a recession, so there is not much leeway to argue there is an additional, large risk premium. Therefore, I would argue we are in stage 2 (i.e. recognition that the event is real and has economic impact but no real panic)
Will we move to Stage 3?
Stage 3 is to be expected if there is contagion in financial markets (apologies that financial crises and pandemics have such similar terminology). Examples include:
- Major negative revenue shocks in corporates leads to credit concerns
- Major negative revenue shock for individuals leads to credit concerns
- The virus will last longer than expected e.g. into 2021
More broadly, what happened in 2008 was that a complex system fails in ways that cannot be predicted with precision. Greenspan perhaps was correct that the 2008 crisis was “unforeseeable” in its exact details. But what was obviously predictable was that the system would fail in ways that would surprise. I do not think I had even heard of rehypothecation before 2008, but soon I had to become expert in it. For coronavirus and its impact, we do not yet know what new things we will have to become an expert in.
My personal journey in this crisis was initially to be far more concerned than most people, but looking back still not nearly enough given how far reaching a pandemic’s impacts are. I initially thought this would be a risk off event leading to a buying opportunity and was simply focused on preserving capital on the way down. In hindsight this was a very tradeable event but it has unfolded far faster than the financial crisis and so you had to be very aggressive very early.
Now we have reached my original target of 2500, I feel I should not be in such a hurry to buy. I am reminding myself that subprime did not destroy the financial system, it merely lit the fuse. Focusing too much on the details of the catalyst can blind us to the far more important second round effects.