Key Takeaways
– S&P 500 closed at 4,455.48 up from 4,432.99 last week. The closing level this week is within a few points of the close two weeks ago.
– Monday saw a vicious sell-off with an intraday low of 4,305.91. Markets closed up 3.4% from that level on Friday.
– Despite the VIX spiking to an intraday high of $28.86, credit markets didn’t budge much, which helped us advise to lean into the sell-off. VIX closed, remarkably, at $17.75.
– Key risks remain to the market and given the intensity of the sell-off (It was a 1/20 probability event since 1970 which last occurred on 5/14/21) there is a greater near-term chance of elevated volatility.
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Last week we used the example of the Yom Kippur War and a daring attack by General Ariel Sharon as an example of how sometimes in the heat of the greatest risk, even though every instinct may be telling you to disengage, retreat, or for our purposes to sell, that sometimes precisely the way out of these perilous situations is to take a calculated risk instead.
The reason we bring this up is because we don’t want you to think of last Friday’s note as linked with this event but rather as a piece of perennial market logic that can always be applied. Contrarian investing isn’t done by people who just talk about tail risks and take the other side of widely used arguments; they are people who take contrary action.
It is hard to take contrary action, and it is even harder when the blood is high and a mix of impulses and chemicals permeate through our brain and impair our decision making and problem-solving ability. This happens to us all on days like Monday, yes we all feel the swoon just as much as you guys do. We promise.
The evolution of the human pre-frontal cortex has been rapid and there is no precedent to its’ speed in all of known evolutionary biology. We became smart fast, but other parts of us can impair this ability which we can all see sometimes makes us seem too big for our intellectual britches. This is what Keynes refers to as animal spirits. It can cut both ways.
Let’s remember the vast majority of human history was a Hobbesian nightmare: life was nasty, brutish and short. Our bodies are designed to withstand and adapt to such environments as we very recently on the evolutionary timeline needed these more animalistic impulses of fight or flight to survive daily life in pre-industrial society.
Now, if we were like some market researchers we would say we saw Monday coming because the narrative lined up nicely. While we did anticipate Evergrande becoming a big story, it is important to understand that we, nor anyone, given current laws of time and space can accurately predict the future. We are always making best efforts to inform ourselves of probabilities that other people may be unwilling or unable to reach, and to think beyond the consensus.
Tom Lee, Our Head of Research, was again a stalwart and calming presence on a day of market chaos when so many seemed eager to throw in the towel. Here’s the thing though, as Tom will elaborate on below, Evergrande is not akin to the Lehman Brother default that broke the camel’s [economy’s] back in 2008. Cognitive bias, as we said last week, is always one of your primary opponents on the competitive field of investing. Like the sport of golf, it is just as much a game against yourself as others.
We think Evergrande is not the straw that will break the camel’s back this time because the camel is much stronger. In fact, it is not even that similar to Long-Term Capital Management’s collapse in the wake of the Russian default. There were tons of US institutions that were exposed to the GKOs, which were short-term Russian government debt that paid 145% or more over short periods.
Despite the very real and ominous risks the market is facing, we don’t see a lot of evidence of the type of Ponzi debt products that defined the twilight of Russia’s post-communist flirtation with democratic governance. Even using Long-Term Capital Management’s collapse as a success story seems a bit dubious since the Russian debt default that triggered it could have been pretty easily prevented by the United States.
So many people were caught so off-guard because they all assumed the United States would bail Russia out for what now seems like an incredibly modest investment. Particularly since the downfall of a nascent Russian democracy to Vladimir Putin’s silovik (translated to people of force) who were waiting in the wings to turn the country into a kleptocratic autocracy, an outcome which has had great costs all over the world and still may continue to.
The decision not to bail a troubled institution without fully understanding the consequences of its failure can be grave as the United States found out in the wake of Lehman Brothers. In their case, the global contagion caused by the influx of foreign capital to higher yielding but equally rated (to comparable treasuries) mortgage backed securities. Evergrande is clearly a domestic Chinese issue. You should also read today’s Fed Watch below to see why you can trust Jay Powell when he says exposure to the US is low.
This week ended on an incredibly good note given the perilous Monday we endured. When you hear the commentators who talk out of both sides of the mouth or spew doomsday bearishness like they’re putting it all on double zero in roulette, ask yourself this question. At anytime in recent history have so many companies survived the unthinkable? The Federal Reserve runs an annual stress test to ensure banks are capitalized in even the worst conditions they can realistically imagine. The 2019 Severely Adverse Stress Test Scenarios was significantly better than what we actually faced successfully during the pandemic. Banks aren’t
overstretched, companies survived extended periods with zero revenue and let’s remember that terminal value and survivability are key dimensions in any respectable valuation.
So, isn’t it fair to say that given the extraordinary and record levels of US wealth, a demographic transition to a highly educated but relatively (to past generations) poor generation who needs to play catch-up on acquiring the wealth necessary for life’s key purchases, and company margins at record highs that it’s not really that crazy at all for markets to be near all-time highs. Oh, and did we mention the virus is getting a lot better. Remember the optimism of April and June? The pent up demand? It didn’t go anywhere according to many statistics.
That being said, we recognize there are a lot of risks and we also recognize that there are some problematic signs with technicals and breadth, but on the wider arc we’re incredibly optimistic. Rates moved past 1.40% which is a big deal and something we see as leading the Epicenter trade which has held up remarkably well over the last month. Energy has been by far the best performer of the last month and WTI inventories that recently came in were very supportive of our macro thesis.
There are undoubtedly obstacles ahead, but there are also glimmers of hope that some of them may be favorably resolved. Tom Block will elaborate on the situation in Washington below. We’re still decidedly glass-half full and we hope you remained so through Monday’s carnage.
