Beware the lure of irrational euphoria in markets

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Movements in the markets are now filled with high levels of uncertainty and volatility. Without deeper analysis of the fundamental developments behind the moves, investors are likely to be confused and find themselves no better than gambling at the casino (if you can even find one opened during this lockdown period, hah!).

As I’ve always said, investments are best carried out in a top-down approach, and while we can’t exactly pinpoint which single reason behind each price movement, it is important for us to try to best understand it with the known information. However, our analysis and close monitoring will allow us to swiftly evaluate current developments to adapt our investment view.

At the time of writing this article, the Dow is at the 24,000 level that we pointed out earlier – a 50% correction of the tumble from the historical highs (as shown below in ‘Chart 1’).

Chart 1

The key questions that investors should ask themselves now is:

1. What led to this rebound of prices?
2. Will the developments from this rebound sustain?

Let’s tackle these questions one-by-one:

1. What led to this rebound of prices?

Chart 2

In the last week, aside from being technically oversold, there were a few key developments (as highlighted in the above ‘Chart 2’):

Trump’s oil intervention: Hopes of an oil agreement sparked by Trump’s verbal intervention, pushing OPEC for a reconciliatory meeting saw global oil suppliers sit down and agree to a 10m barrels per day cut. This gave bulls some energy for an upward charge, forming a floor in the Dow driven by oil stocks.

Trump’s optimism on reopening economy: It wasn’t soon before the Dow moved higher as investors started to pounce on Trump’s optimism, where he mentioned that they might be getting to the top of the “curve” in relation to the outbreak. Investors quickly reacted to his inclination of reopening the US economy with a big bang, buying into any excuse possible.  This was despite recent US data only now beginning to reflect the extensive harm to businesses and it is expected that massive job losses are to follow.

Fed stimulus: Furthermore, the Fed brought out even bigger bazookas by injecting a 2.3 trillion stimulus to small businesses through direct loans. Although this represents roughly 10% of its GDP similar to other countries with COVID-19 stimulus packages, one should not forget that the size of the current government debt and the debt ceiling in the US is an ongoing issue in the White House. How this will lead to further cracks in the already weak & flawed system has yet to be seen…

As you can see from the above, the first step in the global macro approach we employ is to find a fundamental explanation for any move, thanks to our technology investment into AI. This helps one to better analyze any situation and allows us to hinge our future expectations in a grounded manner.

2. Will the developments from this rebound sustain?

Now, looking into the drivers, we start to examine the likelihood of a sustainable move.

The move in oil is an obvious intervention by Trump who since day one of his term has been a loudspeaker for the economy. If oil prices continue to remain this low, many oil producers in the US will be forced to go bust, something Trump wishes to avoid in election year – particularly so in swing states like New Mexico and Colorado who are big in oil production. However, the truth is that oil prices closed at the low of Friday as the market believes that the cut is not enough to offset the reduced demand impacted by the pandemic.

In terms of COVID-19 cases peaking and the reopening of the economy, it is definitely too early to tell. Furthermore, the concern on the intensity of the second wave is still at the top of mind. Judging from the lack of slowdown in cases (in fact cases have been sustaining at peak levels at the moment), economic recovery might take a while as a recession comes into sight.

Regarding the Fed stimulus at close to 10% of GDP, it is similar to the packages from the other economies around the world. However, the US posted a record-breaking number of unemployment claims of nearly 20 million in three weeks and The Economist expects that the unemployment rate will hit as high as 30%. Even as cases start to come down, it will take many months or even years before usual economic activity picks up – one can expect corporate earnings to take a big dent.

So, will prices recover?

As a decent rule of thumb, stock markets fall roughly as much as corporate earnings do. The depth and extent of the global recession indicate that profits should halve this year, but the Dow is now back within 20 percent of its peak. Furthermore, US equities have never taken less than six months to find their bottom, once they have tumbled 30 percent and the economy is in a recession. In the case of the COVID-19, six months is probably just enough to get warmed up, not even an end in sight. Therefore, one must either be a very brave soul or a poker player to call the bottom now – neither of which are roles we want to take when it comes to investing.

So while those banking on a rapid equities market recovery are expecting unprecedented stimulus to erase the pain, history would also suggest they may be banking on a miracle…

How should one position yourself for the upcoming uncertainties and volatilities?

The bounce in the last week was largely driven by irrational euphoria led by voices – the new power of information influences and unruly government interventions to get the risk-on party started again. This has distorted the meaning of a “market”, and we discourage any investor to follow the euphoria just to dabble in speculation. Today’s prices do not reflect the real value, but instead, reflect the will of government guidances. As you can see, Trump is a businessman, and it is no surprise that he has structured a way for him to benefit from his talking up of the market. Rather than reflecting the reality, market prices are now driven by the unseen political and economic agenda of the highest echelon.

As with anything in life, time will tell. We believe that the truth will prevail in the long term, and as such, we aim to go for prudent investments. As the coronavirus has damaged the economy, the layoff of 20 million in three weeks is just the start of rising unemployment, lowered capital expenditure and tighter financial conditions. One indisputable fact is that corporate earnings are going to get hit with the disruption of supply chain and consumption.

That being said, we do not want to write off the impact of the Fed’s unlimited stimulus package in driving the risk-on mood. Even if it is irrational, the market is ultimately made up of its players. So we are keen to watch if such dangerous investment behavior like we see in the QE effect after the 08′ crisis will become the new normalization. Naturally, our view is inclined towards the belief that such euphoria will be difficult to form if the real economy starts to show strong evidence of being badly hurt – something which is quite possible.

Who will win the race, no one knows, as we need more evidence on economic outcomes in order to judge. One thing for sure, is that it holds too much risk to believe now that we will witness a similar replay after the 08’ aftermath…

– RT

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