Chicken Little vs. Alfred E. Newman

“What is the most you ever lost on a coin toss?”

                                                      -- No Country for Old Men

At some point you have to pick a side.

Key takeaways:

o  The CPI number that elicited such a sharp drop and vicious reversal was actually echoing the same action a few hours earlier after German inflation came in at a blazing 10%. The DAX gapped down then rallied as many in Europe wondered if that number could become the peak.

o  Remarks by BOE Governor Bailey put an even brighter market spotlight on Gilts and Sterling.

o  New UK Finance Minister Hunt is committed to returning conservatism to PM Truss’s fiscal policy.

o  Russell Napier has highlighted European governments’ use of bank credit guarantees that will allow them to set nominal GDP and an inflation collar around 4-6%.

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Loose lips can sink more than ships department: Governor Andrew Bailey imitated the teacher in Pink Floyd’s The Wall when he asked UK pensions How can you have any pudding if you don’t eat your meat? His anti kick the can down the road remarks were totally rational but went astray from the “there is a time and a place” etiquette handbook. The Friday deadline for pensions to rebalance came and went without fanfare, which probably means they will have at least until month end, as the Pensions and Lifetime Savings Association had requested.

The BOE had to institute a bond buying program to try to restore order to heavy selling in Gilts due to misplaced fiscal policy promises. Newly installed Finance Minister Jeremy Hunt promised to reverse the expansionary policies made by PM Truss to cut taxes and increase government spending.

The bond buying program is over as of last week, and Governor Bailey said this weekend a big rate November rate hike is coming. Therefore Monday action in Gilts will be pivotal to see if Minister Hunt is seen as credible.

A mess? Yes, decidedly so. Salvageable? Depends on which side you place yourself on the Chicken Little vs. Alfred E. Newman divide:

·        If the sky is falling, then UK pensions deleveraging will create even more turmoil than has been anticipated and will spill over into other parts of the globe;

·        If it is a tempest in a teapot for the “What, me worry?” crowd, Hunt has already set in motion a move to restore conservatism to UK fiscal policy, and the BOE will extend emergency measures as long as required.

By the way, Alfred E. Neuman reversed course only once from his famous slogan, saying “Yes, me worry” after Three Mile Island. So there may be something to the nuclear analogy between the 1979 incident and now. Not just the obvious one with worry over Armageddon, but what if the financial world is on the precipice of annihilation?

I read that there was an enormous option trade Friday with someone betting that the VIX index would hit 100 by next April. This fits with the view that equity volatility has to catch up to bond market volatility, which is trading very much near the peak anxiety of March 2020 pandemic levels:

This chart is the MOVE index, which is the fixed income equivalent of the VIX. If the VIX matches its March 2020 intraday high, it will trade 85. The VIX by the way, has never traded near 100, normally hitting just below 50 in your run-of-the-mill crises. The highest it every printed was 89 intraday on October 24th 2008, the date I believe marked the true bottom of the Great Financial Crisis, although the S&P did make a new low in March 2009.

You may ask, what about the 1987 crash? The day of the crash and the ensuing week did see all time high volatility levels, although it was calculated differently then. The VXO (old VIX) hit 172 intraday on October 19th, which translates to a level above 100 in the VIX.

This got me thinking further—is it a good bet to trade for another 1987-type crash environment? Even the Chicken Littles may be hard pressed on that one. While it can happen, is it the optimal investment strategy?

Since our markets are focused on England’s pension troubles spilling over the US, let’s do a Forest for the Trees analysis on pension portfolios:

Currently, US pension funds are 30% invested in fixed income, with the remainder in equities and alternatives. So the following historical performance data on a 60% equity/40% bond portfolio is not 100% accurate, but it lends a proper historical perspective, and helps us look ahead to see if the VIX will rise to meet the MOVE index at March 2020 highs. This year we have witnessed a bond market drawdown that is the most severe in 70 years, only surpassed by 1921, 1931, and 1948. Looking back at a 60/40 portfolio, year-to-date returns through last week are -21.3%, the worst performance since 1931.

So here we have the Chicken Little vs. Alfred E. Neuman conflict at its purest:

·        Since 1928, a span of 95 investing years, there have only been 20 losing years for the 60/40 portfolio;

·        Of those 20 losing years, including 2022, there have been 6 years where the portfolio experienced double digit losses;

·        Only two other years have seen worse than -20% returns, 1937 (-20.3%) and 1931 (-27.3%);

·        Outside of the negative returns from 1929-1932, there have only been three instances of back to back drops (1940/41, 1973/74, and 2000/01) all followed by substantial bull runs.

So for me, Chicken Little is equated with “This time, it’s different.” While it is certainly possible to drop over 10% to the .618 SPX retracement level of 3200, chances are by December 31st 2022, we will not see the worst performance for 60/40 portfolios in a century.

Russell Napier has come up with a fascinating take on the financial landscape, positing that government’s use of guarantees on bank credit is a return to 1939-1979. The portion of loans backed by state guarantees in Germany, France and Italy are 40%, 70% and 100%. Credit guarantees to commercial banks circumvent raising debt or taxes. This is tantamount to a government taking control of the direction of investment. The most recent example is with energy subsidies. The consensus on the energy subsidies is it going to promote more inefficiencies, but this is actually a way for governments to push credit and money creation in their desired direction according to Napier. He believes we are far away from stagflation, but in the meantime governments will try to inflate away the debt. His clear view is that credit will no longer be controlled by interest rates, but it has become politicized as governments will “set the growth of broad money and nominal GDP”.

Regarding the market, I will spare you from yet another forensic analysis explaining Thursday’s action. The strength of the rejection at 3500 was sufficiently strong and forceful (high volume) that at a minimum it set an important level to restore balance into the market. The question is how long does this balance last. 3500 was the 50% retrace of the entire rally from the March 2020 bottom and retested the gap up that occurred after the Biden victory. It is most clearly seen in the NYSE Composite, and if we close below that gap, corresponding to 3490 in the S&P 500, then the chickens could come home to roost and let the market find a new—lower—equilibrium point.  

My view remains that the risk return landscape still points higher for a better place to put on hedges for longer term players, as the US equity market has absorbed quite a lot of bad news through October.

Peter Corey

PavePro Team

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