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Covid-19 is a world war, re-visited: How to understand the S&P rally

Release Date: 11th May 2020

Like for most, the S&P 500 rebound got us questioning how it came about despite overwhelmingly bad news

Our view on the S&P 500 (which we don’t normally give) worked really well at the start, but no longer looks good. Here is a recap of our views on it:

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From the date of my last view (17th of March), the S&P 500 fell by 6.2% to bottom out at 2,237.4 a few days later, but since then it has risen by 31% to 2,929.80.

In fact, as of market close on the 8th of May, it is now just 12% below the 3,337.8 level of 21st Feb when we first gave our negative view on global markets! What a rollercoaster!

Like most, we have been confused by this market rally as it comes despite the horrific impact on human lives, global economies and corporate earnings.

There countless articles and research reports that give reasons for this rally, and this is just one of them - The stock market's recent surge makes sense if you actually look at the US economy. It also gives links to articles that counter its points that the rally does not make sense

However, the framework of victory explained in our email “Covid-19 is a world war” sent on 17th of March, helps explain this.

From our last email:

But looking at World War 2 – the tide for markets turned not when the war was won, but when victory was in sight and people believed it. This is what we believe would be the key to timing when the S&P is close to bottoming “

Victory in this sense is the idea that we can contain the virus without shutting down economies the way it’s currently being done.

In that email I also said “but I think we are not close to that anytime soon.” Now looking back at how markets performed, it seems that markets gained confidence of containing the virus and ending lock-down, as seen right now worldwide, before I expected them to.

That early confidence is likely further continued by the current reopening of economies worldwide. If this can be sustained and even accelerated, markets might be proved very right to have moved so early.

But as evidenced in the World War 2, it is only when we look back that we knew 1942 was the bottom

“The Dow hit 92.69, its lowest level since 1934, on April 28, 1942.Then the market turned. There seems to have been no single event that triggered it. It was, perhaps, the realization among investors that the U.S. was fully mobilizing for war and would eventually win.”

However, referring back to World War 2, it is only in retrospect we now think of 1942 as the turning point, and our knowledge in hindsight that makes us think that markets called it correctly. We don’t really know the counter-reality, if things had turned out differently and if markets had therefore been proven wrong.

For example, if super weapons, including nuclear programs, that the Nazis were working on had been successful, or military strategies like the D-Day landing had failed, then the market turning around in 1942 could have become an error.

With Covid-19, similar questions can exist. What if the virus fears return, and we have renewed lockdowns and closures of economies? How will markets take it?

Beyond Covid-19, there are also risks of follow-up black swan events

While it is not natural thinking to global market participants, we in Sri Lanka have grown used to back-to-back black swans of different sorts that can follow a system shock like this.

Given that, there is the question of why that can’t happen for the US and the S&P 500.

For an example that is easier to envision, much more elevated US-China tensions could follow. The below article explains it and gives a good perspective of other global risks as well.

This points to an eighth factor: the geostrategic standoff between the US and China. With the Trump administration making every effort to blame China for the pandemic, Chinese President Xi Jinping’s regime will double down on its claim that the US is conspiring to prevent China’s peaceful rise. The Sino-American decoupling in trade, technology, investment, data, and monetary arrangements will intensify.

Worse, this diplomatic breakup will set the stage for a new cold war between the US and its rivals – not just China, but also Russia, Iran, and North Korea. With a US presidential election approaching, there is every reason to expect an upsurge in clandestine cyber warfare, potentially leading even to conventional military clashes

So right now, it feels fair to still be very bearish as there seem to be a lot of Known Unknowns out there about the virus, and a gut feel of risk worldwide of Unknown Unknowns.

I’m holding my view, but I’m a lot less confident in my bearish view

Taking all that into account, what do we do?

For now, I am holding my very bearish view, but clearly with recent market actions being different to my view, I would say that I am a lot less confident of this view.

To put it simply my view is that S&P 500 will fall to at least around the psychologically important 2000 level, but now my confidence in it would be at just a little over 50% probability and it might take more time than I originally expected and it could even take to end 2021.

Another way to understand our bearish view is from this extract:

“There will appear to be a recovery, an ‘all-clear’ for stock prices. It will suck investors back into the market, only to financially ravage them once again.

… Anecdotally, I know this cycle isn’t over as I still receive calls from people who are anxious to get into the market and perceive the current market a buying opportunity. At the bottom of a bear, I should hear great despair and a disdain for stock investing.”

Giving views on global markets is not our expertise and we don’t have an edge

When we sent out past emails such as “Covid-19 is a world war – Why you should look at the market impact this way”, it is interesting to look back and see us saying the following:

“We have found much of the mainstream global Economic and Equity Research lacking and well behind the curve on what’s happening. Global equity market views are not really what Frontier Research has a track record on. We normally just take "current levels" of global markets as the base assumption for our local equity and rates/LKR views.

But given what I have seen in terms of global market research and their outlooks, I feel more strongly in sharing this, given that my view is different and I have a strong conviction in it.”

At that time, to explain this better, we felt we had an edge over most mainstream global research houses, as we were obsessively following the virus and its developments. For us, it was even surprising to see how little attention global research was paying to Covid. Reading global research pieces in February, Covid was typically around 1/5th of factors being considered in Econ and market outlooks.

Of course, what helped us, was following alternative thinkers like Nassim Taleb and Epsilon Theory who were way ahead of mainstream institutions in calling out these risks.

Therefore, our S&P bearishness as a result of recognizing the risks around Covid-19 turned out to be correct at the start.

The mainstream research firms were probably working with their existing frameworks or old framing of outbreaks, and it took them time to adjust and publish any views fast. But they have switched their focus dramatically since then.

It seems that now global research firms have really upped the ante - probably analysing and working on this hundreds of times more than they did during that start of the period, and as such we are now seeing a lot of really great analysis and thought-pieces by them.

For Frontier, one thing we know is that while blogs like Epsilon Theory etc. still have great and alternative perspectives to offer and we use it to inform our own opinions, the catching up of global research firms means that we don’t have a special edge over the market anymore to give a global view (or a better one for that matter) since the big guns are very much following it directly. So, us not calling the big rebound seen since the bottom, might reflect that loss of ground.

In that context, while I have given my view, following it might not be a very good choice anymore and mainstream global research could easily be better, but I hope that these perspectives will still help you come to your own view on the S&P 500 .



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