What Comes After The Crash Is What Counts Most
Investors awakened on March 15, 2023 to the news that a major European bank, Credit Suisse Group (NYSE: CS) had lost the confidence of its major investor, the Saudi Arabia Sovereign fund, which holds 9.9% of the company.
This was the latest set of bad news for the global banking sector whose fortunes quickly reversed when Silicon Valley Bank (SVF) was taken over by banking regulators on 3/10/23.
Sensible investors are probably wondering what took the Saudis so long to lose confidence in a bank whose stock has lost most of its value over the last few months amid news of poor liquidity and a publicized restructuring which never took hold.
Nevertheless, that’s the way these things work. Headlines move markets and markets are run by robot algorithms that read headlines and follow instructions.
The Lay of the Land
Anyone whose been through market crashes, recessions, and bear markets knows that they are painful experiences. They also know that no matter how painful these periods are, until proven otherwise, bear markets eventually reverse and new bull markets emerge.
At the risk of showing my age (using off the top of my head numbers) I’ve been through market crashes in 1987, 1989, 1990, 1994, 1999-2000, 2008, 2018, 2020, as well as the situation which is currently evolving in response to multiple bank failures.
Certainly, the headlines related to each one of these periods are unique. For example in 1987 the market crash was blamed on “program trading.” In 2008 it was all about subprime mortgages. This one is due to a “banking crisis.”
Yet at the end of the day stock all market crashes are due to some quirk in the stock market’s fuel, i.e. liquidity, which is the amount of money that’s available to trade stocks. If you dig deeper, you will find that all market crashes are due to three specific issues related to liquidity:
- The Federal Reserve raises Interest rates;
- Traders have less money to trade as they transfer assets to other expenses, such as keeping the lights on; and
- Eventually, the breaking of the weakest link(s) in the chain, those highly indebted entities/businesses that depend the most on cash flow because they have poor cash reserves due to high levels of debt eventually default.
These businesses are usually poorly run by management whose bad decisions over time eventually pile up and leave them vulnerable.
The net effect is that defaults rise, bills don’t get paid, and eventually the financial system’s liquidity dries up, because parties stop interacting with other parties and the flow of money in the system stops. This happens every single time, without variation regardless of the headlines or the reasons cited.
Reasons blamed for the crash vary, whether it’s computers that go haywire (1987) or a pandemic (2020). But history shows that when the Fed raises rates, the financial system reaches a point where highly indebted companies, and companies that do business with highly indebted companies that fail to pay their bills, eventually run out of money and a cascade effect develops where liquidity dries up and stocks crash.
Where Are We Now?
Currently, we are in what I would describe as early days. That’s because we know that regional banks are undercapitalized. But we don’t know how many or how bad the situation is for any of them. Moreover, the Fed has begun to remedy the situation via individualized bailouts and deposit guarantees, but has not issued a “whatever it takes” statement as they did in 2020.
There is still a lot that can happen. For example, although it’s an unknown risk at the moment, a big bank could still fail if its customers suddenly stopped paying their loans and depositors decideed to pull out their money.
Credit Suisse used to be a big bank. Think for example Citigroup (NYSE: C) or something along those lines. And no I’m not predicting Citigroup will crash. It’s just an example. Moreover:
- The status of inflation is still not fully known, although it seems to have flattened out according to the February 2023 consumer and producer price indices;
- The geopolitical situation is volatile with the Ukraine situation evolving, with maybe peace talks or a worse situation developing;
- The status of the U.S. dollar as a reserve currency is being questioned;
- Global commerce and supply chains are still in flux; and
- There is always the potential that something completely unexpected (Black Swan) could appear at any moment…think tensions among Washington, Moscow, Beijing, Ukraine, and North Korea.
It helps to start with the big picture. I look at five major factors:
- The market’s breadth: the ratio of advancing stocks to declining stocks on the New York Stock Exchange (the New York Stock Exchange Advance Decline line- NYAD);
- The level of bearish sentiment (the CBOE Volatility Index (VIX);
- The status of the market’s liquidity (the Eurodollar Index, (XED);
- Whether the market is overbought or oversold (the Relative Strength Index, RSI); and
- The action in the U.S. Ten Year Note yield (TNX).
In the current market, it’s obvious that more stocks are declining than advancing, with NYAD in a down trend. Moreover, the line is below the 200-day moving average, which puts it in bear market territory. Bearish sentiment is rising, as VIX moves decidedly higher.
On the other hand, XED is maybe bouncing, which means that the market’s liquidity may be improving, while RSI is hovering near the 30 area, which is oversold territory.
Believe it or not, this is a neutral reading of the market’s condition. Even though stocks are in a down trend, there are emerging signs that some sort of bounce will materialize based on what comes out of the Federal Reserve in regard to interest rates.
Finally, the yield on the TNX recently reversed its climb toward the 4% level. On 3/15/23, TNX broke below 3.5% and its 200-day moving average suggesting that traders are now betting that the U.S. economy will fall into recession and that the Fed will be forced to lower interest rates.
It’s What Follows That Matters
It’s terrible when markets crash. But what follows is often a highly profitable period. That’s because when the Fed realizes that its actions caused the crash, it often reverses its campaign toward higher interest rates.
This behavioral change from the central bank, along with its measures such as qualitative easing (QE), the aggressive injection of money into the financial system, eventually perks up the so-called “animal spirits” on Wall Street and stocks embark on new bull markets.
The problem is that it’s not so much a question of if “animal spirits” will rebound, but more of when. For example, after the subprime mortgage crisis bear market in 2008, it took the Fed 10 interest rate cuts (September 2007 to December 2008) before stocks finally began on a new bull market in early 2009.
On the other hand, in 2020, the response from the market was immediate when the Fed injected record amounts of money into the system and made it clear that it would continue to do so for as long as it took. That was about three years of big chunks of easy money, and what ensued was a huge bull market in stocks.
The Situation Remains Fluid
If history is any guide, these are early days in this saga. That’s because all banks do business with other banks. We don’t know which will be the next bank to fail and which other banks won’t get paid because of that failure.
Making matters worse is the extent of the potential damage from the derivative market. That’s where huge off-the-book bets on potential outcomes are made as both hedges and pure speculative bets.
In the 2015 movie The Big Short, we learned how the world of credit default swaps (CDS) works. We also know that the extent of what was going on in that murky place prior to the SVB debacle is likely to emerge in the next few days.
That’s because the traders who were right with their CDS investments based on this type of scenario unfolding will want to collect their debt from the guys who got it wrong. And the guys who got it wrong will likely have to sell liquid assets such as stocks to pay the debt. Poorly capitalized banks that took the wrong side of the CDS bet against smarter traders could find themselves in dire straits. They may also collapse.
On the other hand, the Fed is likely to panic at some point, because nobody wants to be blamed for financial Armageddon and political pressure mounts. If history repeats itself, the Fed is about to panic and change its mind about holding interest rates “higher for longer.” When the Fed folds and makes it clear that it will do “whatever it takes” to keep the economy from collapse, the market will respond.
It’s that response that matters most. If we get a 2007-2008 response, things will get worse. If we get a 2020 response, we may see another bull market emerge from the ashes of yet another Federal Reserve policy error and its consequences.
What’s the bottom line? Review your portfolio frequently and act accordingly based on your financial needs and timelines. Also make a shopping list for stocks which you may add to your holdings when the Fed capitulates.
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