• Samuel Zavaletta

Eye of the Storm

The market has recovered substantially from the lows of the correction, having made it roughly halfway back to where it started. This is a key psychological moment, as wary investors flush with cash see gains accruing and consequently feel pressured to reallocate to risk assets. The deflation of risk is reflected in the VIX, a CBOE measure that illustrates the short-term implied volatility of the S&P 500 Index:

data sourced from Bloomberg, LP

You can see several elements in the chart above. First, the level of the VIX is displayed by the candlestick pattern. Next, there are several moving average lines (10-day, 60-day, and 200-day). Finally, I drew a bandwidth illustrating levels of implied volatility that were reached in previous periods of stress.

Following is a chart that looks at the VIX in a different light. Here, we take the VIX and subtract the 180-day historical volatility of the S&P 500 Index:

data sourced from Bloomberg, LP

The takeaway from these charts is relatively clear. After reaching high levels of stress, the market is cooling off. There are a number of positive developments that have resulted in this easing of tension, notably (a) pronounced fiscal stimulus, (b) pronounced monetary accommodation, (c) the deployment of emergency federal and state capacities, and (d) moderation in the virus death toll projections for the United States.

The worry on everyone's mind is whether or not this bounce is really just a "head fake" before the market continues south. Given the substantial economic toll that the containment measures have already imposed - today unemployment jumped to approximately 13% - one really must ask oneself whether the market has gotten ahead of itself. Such a pronounced bounce seems premature when the economic toll has not even had a chance to work itself through corporate balance sheets for one or two quarters. For comparison, the following chart shows the S&P 500 Index going back to before the Great Recession:

data sourced from Bloomberg, LP

You will see several elements in this chart. First, the S&P 500 Index is illustrated by the candlestick pattern. Next is a long-term moving average line in solid white, with two shorter-frequency moving average lines also illustrated with solid lines. Finally, there is a bandwidth in dashed white lines of the implied price of the S&P 500 Index at three separate PE ratios based on trailing-twelve-month earnings. If you look at the notes I've included, you'll see that unlike the Great Recession - where the market followed an earnings downcycle into a depressed valuation range - neither of these circumstances has occurred in this latest crisis.

Given the scale of economic distress this virus is imposing, it stands to reason that a tactical investor may yet find opportunity to the downside. There are still many things that can go wrong, from holdups in the transmission of fiscal and monetary policy, to a resurgence of the virus projections.

I believe we have entered the eye of the storm. Will it die down, or shall we encounter the second storm wall? Is this a V-shaped recovery, a U-shaped recovery, or an L-shaped recover?

Guard thine self.

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