Markets walked off the cliff. Will they look down?

What Just Happened?

Some mighty moves in the tectonic plates of the global economy are afoot. You can read my latest take on the deep significance of what is happening in this column, which expands on yesterday's newsletter. For now, I will try to explain what has just happened, which is hard enough.

First, and beyond denial, what we are seeing is a bona fide response to genuinely new news. Truly exogenous shocks don't happen often, as I have said recently. This time, two huge and unconnected shocks have come within days of each other — the spread of the coronavirus beyond China, and the breakdown in OPEC's discipline. Both give good reason to mark down expectations for corporate profits and economic growth. Nothing quite like this has happened before. 

As my colleague Matt Levine argued, this is the basic point that has to be made here, and there are dangers in over-complicating. It will be hard enough in the days and weeks to come just to work out the true economic impact of the oil price shock and the virus — no need to bring in other problems.

Unfortunately, I do believe that it is necessary to complicate things a little further. One common element in market crashes over the years is that an initially valid logic gets taken way too far, until it crashes upon itself. It is a little like, to use an analogy that came in very handy in 2008, the moment when Wile E Coyote looks down for the first time, having walked off the edge of a cliff. Only then does he fall.

The utter mayhem of 2008 shows the performance of oil futures relative to US bank stocks. At the beginning of the year, the theory was that the US financial system was doomed, thanks to subprime lending, but there was a haven to be found in the emerging world, led by China, which had decoupled from the Western economy and would keep growing and consuming raw materials. Hence: long oil/short American banks. This trade made a stunning 150% over the first half of the year, until reversing suddenly on July 14 (Bastille Day). By the end of 2008, amazingly, US banks' price performance had beaten that of a barrel of oil.

This was a case of logic collapsing upon itself. If the US banking system was really on its knees, it was crazy to think that there would be enough demand to sustain oil at record prices. The trade might have made some sense at one point, but ultimately the two sides affected each other, and there was no way that they could co-exist. 

In a similar way, I would argue that some long-used logic has been taken too far. One of the most fascinating elements of the last few weeks is that the dollar has weakened, sharply, against its largest developed-market trading partners. This is despite the huge sums evidently flowing into Treasuries, and the long-established pattern for investors to run for the shelter of the dollar when there is trouble. The currency strengthened after the Lehman bankruptcy, and again after the US credit rating downgrade by Standard & Poor's, two major shocks that emanated from the US The dollar also tends to have a close inverse correlation with the oil price, and rose sharply during the major oil sell-off after OPEC's last loss of discipline in late 2014. So the fall in the dollar needs to be taken seriously. And that is particularly true because it suggests that the logic underpinning a belief in American exceptionalism is at last being tested. Since 2011, US stocks have gained more than 150% while the rest of the world has gone nowhere.

Arguments supporting this include that the US is the progenitor of the mighty FAANG stocks (named after leading technology companies), that it has benefited from the shale revolution, and that it responded better to the crisis than others. The FAANGs are still performing. Shale is evidently now under direct attack. And the response to the crisis is also coming into question. For years, US bond yields have been far higher than equivalent German bunds, reflecting the belief that the Federal Reserve could normalize while Germany was stuck with negative rates. That assumption is now dramatically under challenge. In a globalized world, it is hard to see how one country can enjoy a robust economy while all others are in trouble, and the shocks of the last few days and weeks seem to have brought this logic home to investors.

As people spot the logical fallacy in American exceptionalism, they also begin to spot the fallacy in TINA ("there is no alternative") — the notion that low yields make bonds such bad value that it is justified to pay high multiples for stocks. The problem with this, rather as with the "long oil/short banks" trade back in 2008, is that at a certain point the rationale no longer works. Bond yields of less than 1% only make sense if the economy is bound for a long drawn-out deflationary recession. And if that is the fate of the economy, the effect on stocks will be horrible. This little item of logic also appears now to have clarified itself in the mind of investors, helped by the twin shocks of oil and the virus. 

We can illustrate it with the relative performance of the most popular US exchange-traded funds for stocks (SPY) and long-dated bonds (TLT). Without even taking yield into account, we can see that after the sudden sell-off of the last few days, SPY has performed no better than TLT over a period going back all the way to 2003. Toward the end of 2018, as the chart shows, SPY's outperformance had been very impressive. Now, that trend has collapsed under the weight of its own logical implausibility.

Meanwhile, if we look at the internals of the US stock market, this still looks like a fundamentally rational and orderly sell-off, even if circuit breakers were needed briefly in Monday's morning session. Oil exploration companies, hotels and cruise lines, and banks — all obviously damaged by the twin shocks — led the decliners. The few stocks to gain represented the few companies that might stand to benefit from the virus, including dollar store operators, makers of hygienic wipes, and producers of canned food.

But there is still no reversal of the underlying premise which has guided the market for years, which is that it is worth paying up for the few companies that can show profit growth (such as the FAANGs), and avoiding value stocks, which are cheap compared to their fundamentals. Value investors haven't lost the faith, and invested on the basis that value would at last shine in the downturn — but in fact value's underperformance has intensified as market action has grown more manic.

Value stocks include many banks and energy companies, and stocks with poor balance sheets. They were pummeled Monday. There is logical validity to the notion that growth is scarce at present, and so we should pay more for it. But can growth stocks really keep growing if many of their value brethren go to the wall? Or could there be a moment when the coyote looks down?

Disclaimer: This article first appeared on Bloomberg.com, and is published by special syndication arrangement.