White Paper: How Hempel Wealth Management called the Market Top in February 2020
The Fastest 30% Sell-Off in History.
Investors around the world were caught off guard with the ferocity of the market plunge. The swift collapse has left many with more questions than answers. Many financial advisors have been scrambling to provide an explanation.
As the crisis grows, more and more clients, investors and other financial advisors have been asking how we called the market top. The first thing to know is this is our specialty. The technical jargon is Tactical Asset Allocation; normal people call it market timing. Some say it is impossible, but then again, most things that are very challenging have that label.
In the investing industry, financial advisors specialize in all kinds of things. We don’t sell insurance or annuities. We do not specialize in squeezing every penny out of Social Security. Our focus, our specialty, the reason our firm was founded is to practice what we call “quantitative risk management”. Hempel Wealth Management is one of only a handful of registered investment advisors in the country who specialize in this discipline.
What is Quantitative Risk Management?
Quantitative finance is the use of mathematical models and extremely large datasets to analyze financial markets and securities. Risk Management is the practice of analyzing and forecasting threats to your objectives and applying resources to control the impact of unfortunate events. Therefore, Quantitative Risk Management is the use of mathematical models of large financial datasets to control the impact of unfortunate events to your financial goals.
Wile E. Coyote vs. the Road Runner Economies go through cycles of boom and busts. Countless books, academic papers and research commentary have been written over the centuries. The story is always the same, just like Wile E. Coyote and the Road Runner. The Coyote misses a sharp turn and runs right off the edge of a cliff. With a shocked expression, he looks down, realizes it’s too late and free falls. It’s funny in a cartoon. It’s not so humorous in real life, seeing your investments run off the cliff.
The National Bureau of Economic Research has documented 33 business cycles in the United States since 1854. In the modern era, the U.S. economy averages five years from bottom to the economic top. Earlier this year, the United States celebrated the 11th birthday of a growing economy and a bull market; the longest bull market in recorded United States history.
One of the many difficulties in understanding recessions is that sometimes economists do not know there was a recession until a year after it started. For instance, the Great Recession began in December 2007, the National Bureau of Economic Research announced the recession on December 1, 2008.
Economic Status of the World
At the end of 2019, before the coronavirus became global news, the world’s economy was already in a precarious position. Four of the five of the largest economies in the world had their economies at decade or multi-decade lows. The United Kingdom was forecasting future economic growth to be the slowest since World War II. Germany just had its worst year since the Great Recession. Japan was widely expected to already have a recession underway. China was seeing its slowest growth in 30 years. The United States was in better position than its closest peers, but was hardly worry free with a set of flashing red economic alarm bells going off.
Each country was facing its own problems for its own reasons. The UK shot itself in the foot over Brexit. The German economy is heavily dependent on exports and has been suffering as the Chinese economy slowed, especially since China has been Germany’s most important trading partner for the last four years. China’s economy was facing the impact of the U.S. trade war as well as numerous internal challenges.
With the ever increasing interdependence of global trade, each country can easily blame their local problems on weakness abroad. With so many of the most significant global economic players in a worsening economic position, it was foolish for investors in the United States to think that everything was fine.
0% growth in the United Kingdom, the 5th largest economy in the world
UK gross domestic product stalled in the fourth quarter, recording a 0% growth. The Office of National Statistics stated the “underlying momentum in the UK economy appeared to be slowing.” This concerning report followed the news that the UK economy shrank in November. Over the 12 months of November 2018 to November 2019, the economy only grew by 0.6%, the weakest pace in nearly a decade. The Bank of England forecasted that the economy will rebound in 2020 and grow at 1.1% over the next three years, the lowest prospects for the economy since World War II.
0% growth in Germany, the 4th largest economy in the world
As the world’s third-largest exporter, Germany acts as a bellwether for the global economy. 2019 revealed the weakness of the German economy and only grew at 0.6%. In the second quarter, GDP fell 0.1%. In the third quarter, GDP grew at 0.1% as export-focused sectors suffered. In the fourth quarter of 2019, GDP stalled, reporting 0% growth.
Recent reports showed that the German economy stagnated with exports falling by 0.2%, confirming that Europe’s largest economy was in trouble even before the coronavirus outbreak began. Germany’s economic outlook for 2020 was an anemic growth of only 0.7%, barely better than 2019, which was widely seen as the worst year since the Great Recession.
Recession expected in Japan, the 3rd largest economy in the world
On October 1st of 2019, Japan raised its national sales tax to 10% from 8%. Previous tax increases, in 1997 and another in 2014 had both brought on recessions. Prime Minister Shinzo Abe twice delayed the move out of fears it might derail the tenuous expansion of the world’s third-largest economy. But he said this time it was unavoidable. The move was seen as critical for fixing the country’s tattered finances as Japan has the industrial world’s heaviest public debt burden. A Japanese recession was widely anticipated.
As expected, Japan’s retail sales dropped for the third straight month in December after a larger-than-expected 2.1% drop in November. Consumers continued to cut spending after the sales tax hike. The alarming news was that Japan’s fourth quarter factory output fell at the fastest pace on record. Factory output fell 4.0% after sluggish demand both domestically and abroad.
The Japanese economy is expected to contract in the fourth quarter as a result of the sales tax hike. In late 2019, there was hope that the economy can get back on its feet [in January through March] to avoid a recession. The economy was viewed as weaker than previously projected with the fall in factory output and ongoing decline in retail sales.
Slowest growth in 30 years in China, the 2nd largest economy in the world
In the second half of 2019, the Chinese economy grew at the slowest pace since records began in March of 1992 in the fourth-quarter and the third-quarter; both measuring at 6%, a near 30-year low.
While some analysts blame the trade war with the US, experts from Wharton and Stanford University suggest that the challenges to China’s economy are deeper, structural, longer term, and have been building for years. They include over-investment, high savings and modest, if growing, consumer spending, high debt and low industrial productivity.
Economic Status of the United States
Countless market commentators have “cried wolf” the last decade that a U.S. recession is imminent. They of course were proven wrong and presumably missed out on the extraordinary market returns. From the end of March 2009 to the end of January 2020, the S&P 500 was up over 400% with dividends reinvested. Selling early is the same thing as being wrong. To get an understanding of when an economic cycle peak may occur, our framework for managing investment risk pays close attention to three leading economic indicators.
New York Federal Reserve & Yield Curve Recession Indicator:
Normally, borrowers pay higher interest rates for a long-term loan and a lower rate for a short-term loan. In normal economic environments, a 30-year mortgage will typically be a higher interest rate than a 15-year mortgage. An inverted yield curve is when this relationship is backwards. In an inverted yield curve, borrowers pay more for short-term loans and a lower rate for longer-term loans. As you would expect, this creates a distortion in the economy.
It’s well known that in the United States recessions are often preceded by an inversion of the yield curve. The inverted yield curve has predicted every U.S. recession for the last 70 years, since 1950, with only one “false” signal, which preceded the credit crunch and slowdown in production in 1967.
Research by the New York Federal Reserve shows that once the yield curve inverts, there is an extremely high likelihood of a recession occurring, typically 12 to 18 months later. There is also evidence that the predictive relationships exist in other countries, notably Germany, Canada, and the United Kingdom.
For five consecutive months in 2019, the ten-year and three-month U.S. Treasury yield curve was inverted. This led the Federal Reserve to make three interest rate cuts in 2019 totaling 0.75%, to correct the yield inversion and reduce the risk of a recession. Then in January and February 2020, the ten-year and three-month treasuries had once again inverted.
According to the research, adding 12 to 18 months to the August 2019 date implies there was an extremely elevated risk of an economic contraction starting in mid 2020 and into early 2021. Of course, knowing this does not tell you exactly when there will be a top, but it should tell you to keep an eye out for the turn that Wile E. Coyote missed.
The Federal Reserve Bank of Philadelphia Recession Indicator:
The Federal Reserve Bank of Philadelphia predicts the next six months of economic growth for each of the 50 states. The model includes variables such as state-level housing permits, state unemployment claims, the Institute for Supply Management (ISM) manufacturing survey, and the interest rate spread. In the January 2020 report, the Philadelphia Fed predicted that nine states (CT, DE, KY, MO, NJ, OK, PA, VT, WV) will have negative GDP growth for the following six months (i.e. a state-wide recession). The concern is not only that the count of nine states is alarmingly high, but also that the number has been rising in the prior few months. In a normal month, during a growth period, only one state will be predicted to slow down.
Duke University CFO Global Business Outlook:
The Duke University study of over 1,000 Chief Financial Officers in companies around the world is an extremely early indicator of potential economic trouble as these individuals have their fingers on the pulse of the global economy. In December 2019, the Duke University/CFO Global Business Outlook reported that more than half (52%) of U.S. Chief Financial Officers believe the U.S. will be in an economic recession by the end of 2020, and 76% predict a recession by mid-2021. Seventy-nine percent of CFOs in Asia believe their countries will be in recession by the fourth quarter of 2020, as do the majority of CFOs in Africa (77%), Canada (67%) and Latin America (55%). Forty-nine percent of CFOs in Europe expect a recession by the end of 2020.
Part of this is self-confirming bias. Suppose you are a CFO of a major company and you don’t believe a recession is coming, but a majority of your fellow CFOs do. Your peers are busy preparing their respective companies for the perceived economic storm, but since you don’t believe there will be a recession you are inclined to not prepare your company. Do you believe all the other CFOs are wrong? Are you willing to risk your multi-national corporation over this idea, or should you start to prepare a bit as well, cancel a project here, and delay spending other there?
The Financial Markets
In a simplistic view, the financial markets are split in two parts. Equity and Debt, better known as Stocks and Bonds. What is not widely known is that the size of the global debt market is three times as large as global stocks. The value of the global stock markets is approximately $90 trillion. The value of the global debt likely exceeds $255 trillion by the end of 2019. Said another way, 25% of the combined value is stocks, 75% is in bonds. Based on the size of the markets, it would be rational to expect 75% of financial professionals to be experts in bonds and 25% to be experts in stocks.
The Bond Market is Smarter than the Stock Market
Equities/stocks are the junior piece of the capital structure of companies which means equity investors have the highest risk and the greatest loss in the event of bankruptcy. One would think those with the most at risk, would care the most about the state of the economy, but stock investors care the most about future corporate profits. Bond investors care most about inflation and inflation is driven by the performance of the economy.
An old Wall Street adage asserts that the bond market is smarter than the stock market. One of my favorite financial analogies comes from Jeremy Grantham, who likened the financial markets to a brontosaurus. It takes a long time for information to go from the dinosaur’s head to its tail. The bond market is the brontosaurus’ head, which sees something and tries to react, while the stock market at the tail, is the last to get the news.
If nothing else, the bond market is a gauge of the consensus expectation of the economy at any given point. In early 2020, the bond market had been expecting a recession in the United States for months and months. The stock market was setting all time highs, day after day. An investor in the S&P 500 was willing to pay $19 for $1 in forward earnings, its highest valuation level in almost 20 years. When will the stock market get the message?
Coronavirus in January
As of January 31st, the coronavirus outbreak in China had killed more than 213 and infected more than 10,000 people. The province of Hubei and Wuhan, it’s capital city, had been under quarantine for weeks, with almost every city facing travel restrictions in a province home to nearly 60 million people.
At the time, the countries with confirmed cases included Australia, Cambodia, Canada, France, Germany, Japan, Malaysia, Nepal, Sri Lanka, Singapore, Thailand, South Korea, the UAE, the United States, and Vietnam. The WHO had declared a global health emergency.
Everyone could see the impact on the Chinese economy, which was already at its weakest point in over 30 years. Investors could extrapolate what it would do to the European economies, which was already on the brink. The risk of a global recession had undeniably increased.
The stock market kept going up.
Being early is the same thing as being wrong. Individuals who sold when China first went into lockdown were proved wrong. Just as those who sold during the countless other crises in the past decade. The WHO had declared a global health emergency, but stock investors didn’t expect an impact to companies’ earnings. The stock markets kept going up.
Hempel Wealth Management’s Investment Approach
Our philosophy is rooted in the fundamental belief that investors should be compensated for saving their money and compensated for the risks they take with their investments, regardless of the economic environment and in any investment strategy. You can not avoid risk when investing, but you can make smarter decisions.
At the heart of our philosophy is how we think about, view and analyze risk. As risk-aware investors, we strategically use risk to achieve our investors’ desired outcomes and seek to minimize the unintended consequences.
The stock market is largely efficient and mostly random. When it is not, opportunities can appear. Quantitative finance is a field of mathematics regarding the study of stock market data. This technology was once affordable only by Wall Street firms. With the rise of the modern computer era, it has made it possible to crunch enormous volumes of data in extraordinarily short periods of time.
Our Quantitative Risk Management Model
There are two ways to estimate what the financial markets will do in the future. You can come up with an answer yourself or you can copy the answer from a neighbor. We do both.
First, we determine the most likely price and range of tomorrow’s stock market based on regression analysis and artificial intelligence of historical patterns and correlations. This proprietary quantitative financial model (p < 0.05) was constructed over a period of many years through a rigorous analytical process. Second, we derive the most likely price and range of tomorrow’s stock market based on what the market thinks by analyzing the price of stock options and market volatility. By comparing these two numbers with what actually happens, you get three different possibilities. We were right and the market was wrong. We were wrong and the market was right. Or we were both wrong.
By having an idea of what will happen in the future, we can calculate investment risk. Countless books have been written on the subject and there are multiple ways calculating risk is performed. We use two of the more common methods. We calculate something called Value at Risk. Based on known market conditions and probabilities, Value at Risk estimates the how bad things can get in the near future. We can also calculate Expected Shortfall; this tells us our expected loss, if we assume that things will go bad.
The Market Top
The stock market was setting all time highs, day after day. On Friday, February 21, 2020 an investor in the S&P 500 was willing to pay $19 for $1 in forward earnings, its highest valuation level in almost 20 years. The S&P 500 closed at an all-time record high just two days prior.
We calculated what we thought would happen over the weekend. The Stock Market calculated what it thought would happen over the weekend. We were both wrong. On Monday morning of February 24th, the stock market opened sharply lower. Noticeably lower than what either we or the market expected to happen. The losses were stressing what the Expected Shortfall model had expected would happen if things went unquestionably bad.
Coronavirus as of February 24, 2020
Over the weekend of February 21st, news of the coronavirus exploded. Italy announced more than 150 cases, many in the densely populated region around Milan. Officials closed schools and canceled Venice’s carnival. Tourists wore protective masks as they walked past the Colosseum in Rome. It was the largest outbreak outside of Asia. A widespread European infection was now a real possibility.
Connecting the Dots
As the market sold off throughout the day on Monday February 24th, it was time for a reflection on the status of risk in client’s portfolios:
- Did the tail of the brontosaurus finally receive the message?
- The U.S. bond market, multiple Federal Reserve recession models, and Chief Financial Officers are all sending flashing bright red warning signs about the U.S. economy.
- The Chinese economy was at 30-year lows and is now getting ravaged by the Coronavirus outbreak.
- The Japanese economy was already widely expected to be in recession. Japan had limited large social gatherings and the Tokyo Marathon would be restricted to elite runners only.
- There was also a cruise ship full of sick people.
- The European economy was on the ropes and now there is a real possibility of a wide-spread outbreak.
- The coronavirus was no longer contained and spreading globally.
- The WHO had declared a global health emergency a month ago.
- A few days ago, the U.S. stock market set a record high and was at it’s the highest valuation level in almost 20 years.
- On Monday February 24th, the market sell off was more than what was statistically likely.
- Something big was happening.
In the race between Wile E. Coyote and the Road Runner, the Road Runner had just turned and the cliff is coming. If we were wrong, that was the all time high and the most expensive point in the last 20 years. If we were right, the stock market still had a long way to fall.
Hindsight is always 20-20; it is easy to be the Monday morning arm-chair quarterback. To connect the dots in real time is very difficult. Unfortunately, many investors around the world didn’t get the message and were caught off guard with the ferocity of the market plunge. Most people do not have the patience, the time or the desire to read books on game theory, risk management and economic cycles and apply it on a daily basis.
We are not clairvoyant. We can not predict the future with certainty. We simply think about, view and analyze risk differently that most financial advisors. When the odds are strongly against our clients, we seek to protect their life savings.
If you got to this far, I want to thank you; I hope you learned something new. If you know of someone who could be helped by our practice, please connect us.
Founder of Hempel Wealth Management