A Time to Buy?

A Time to Buy?

In 1815 during the aftermath of the British victory over Napoleon at the battle of Waterloo, there was a crash in the British financial markets. It is rumoured that Baron Rothschild, an 18^th century British noblemen and part of the Rothschild banking dynasty, got advanced word that the British had won the battle, went into the markets and sold heavily. Rumour spread that the battle had been lost and panic ensued with prices crashing. At the market lows, Rothschild went back into the markets and bought heavily, closing out his positions for huge profit.

Irrespective of whether he started the rumour or just capitalized on the panic, afterwards he was credited with the expression ‘Buy when there’s blood in the streets’. This rather graphic phrase perfectly illustrates the trauma associated with market crashes. When markets move from a correction to a crash, panic replaces rational thought. The fear becomes all pervasive and any thoughts of value fly out the window. It is simply about preserving what you can and selling at any price. This stampede to the exits is exciting to witness but gut wrenching for those investors caught on the wrong side of the trade.

The equity markets were probably due a decent correction after experiencing a particularly long and relentless phase of rising prices. As we know, even the strongest bull markets need periods of consolidation to blow off the froth that happens periodically and the longer a market moves without one, the bigger the consolidation will be when it arrives.

When news first started to emerge of a new virus in Wuhan, the markets were incredibly resilient. It was only when the virus appeared outside of China that the markets started to react. After an initial slump and rally, the world was greeted by the news that a price war had started in the crude oil market, after OPEC members refused Saudi Arabia’s suggestion to scale back their production in the light of falling demand due to the effects of the virus. As a result, Saudi scaled up production and offered deep discounts on its prices in order to force a resolution. As the world’s largest and cheapest producer of oil, this is a fight that Saudi will ultimately win, but until it resolves, it will cause immense damage to the other oil exporting countries around the world. This turmoil led to oil prices falling 30% initially, and the price falls have continued.

This kind of move would upset the financial markets at any time, but in their current fragile state, it was particularly damaging. As liquidity in markets dries up and losses mount, banks and other financial institutions are forced to start selling other assets in order to raise funds. This drives the volatility, leading to wild swings and mounting losses. As credit conditions become tight, banks refuse to lend to each other, fearful that the other institutions might be in trouble. At this point the central banks have to step in to provide liquidity to prevent the whole system blowing up. We have seen this recently with the US Federal Reserve offering up to $500 billion daily to ensure adequate functioning of the credit system. Central banks around the world have also made drastic cuts to interest rates in order to support the system and try to offer some relief to borrowers. These stresses and strains within the system have resulted in some financial institutions facing huge losses.

If all these factors weren’t already enough to induce a panic, the authorities reaction to COVID-19 has been nothing short of astounding. As the virus has progressed we have seen differing responses from governments around the world. Some have been almost relaxed in the face of its progress, others, including many of the countries that felt the force of the SARS outbreak of 2003, have been more proactive in reducing its transmission. China has shown what can be achieved when draconian measures are taken to shut down all movement. Drastically reducing the number of people infected, reducing the speed of transmission and buying the health services time to respond and not be overloaded. This now seems to be the template that governments are following around the world and it will work. It is undoubtedly the most effective way to combat the transmission of any and all infectious diseases.

The question though is at what cost?

The measures being enacted around the world will have a dramatic effect on the global economy, the likes of which we have never witnessed before. We will see a truly global recession, with many businesses being bankrupted and millions of people losing their jobs. The costs associated with fighting COVID-19 and the lasting repercussions will be staggering.

I could understand it if we were facing a global outbreak of Ebola. With a mortality of rate of up to 90% it truly is something to fear. In those circumstances, shutting down the global economy would make perfect sense, as failing to act would result in there not being a global economy! But should we really be acting the same way for a virus that although likely more dangerous than seasonal flu, still only appears to have a mortality rate of 1.4%  https://www.statnews.com/2020/03/16/lower-coronavirus-death-rate-estimates/  Are there really no other measures we could be taking? As the mortality rate is so much higher amongst over 70's and those with underlying health issues  https://www.bloomberg.com/news/articles/2020-03-18/99-of-those-who-died-from-virus-had-other-illness-italy-says, would it not have been more sensible to spend money and resources isolating those people and allowing the global economy to continue to function? 

Are we going to stop the global economy the next time a virus appears? 

Because there will be a next time.

I think we are witnessing a version of the panic we normally associate with stock market crashes. In the media’s quest for click bait, the avalanche of evermore lurid and fear mongering news headlines has had an effect on peoples psyche until we have finally arrived here, with the economy in almost total lock-down and people fighting in supermarkets over toilet paper, a situation that most people couldn’t have imagined even three weeks ago.

For a final word on human nature we can turn to the wisdom of Agent Kay in the Men in Black movie. In response to Will Smith saying that people are smart, he replies,

“A person is smart, people are dumb, panicky, dangerous animals and you know it!”

In a years time, when the dust has settled on all this, there will be some serious questions to answer. I fear we are currently using a seriously big sledgehammer to crack a nut.

So, having got some perspective as to why the markets are reacting so violently, has this changed my views that the US equity markets will turn around and go to new all time highs? Or that the US dollar will continue to strengthen? Or that the precious metals will once again show some spectacular gains? The simple answer is no, because once we have worked our way through this period of turmoil, investors will once again face the same challenges they did before. And the shortlist that existed before this crash will remain the same.

 Currency risk will be the key driver. As I've mentioned many times before, there are only three currencies that can cope with the volume of trade needed to be a truly global currency, they are the Euro, Japanese Yen and the US Dollar. The euro zone was already in serious strife before this crash, with the financial hole left by Brexit finally highlighting how financially exposed and disparate the zone really is. The COVID-19 effects will expose the harsh reality of a flawed political union as member states abandon the one zone theory and return to every country for themselves. We were already seeing weakness in the euro as money left the zone in search of US dollars. This was temporarily reversed in the early stages of this crisis as emotions took over and money was repatriated, however we have now seen a surge in US dollar buying as we can see from the chart below. Sidebar (you might also ask why money doesn't flow into the Yen instead of the Dollar. The reason is that Japan has its very own set of mammoth problems that will manifest in the not too distant future, so for the present time, the US Dollar will remain king).

  We are also able to get an idea of the potential upside for the Dollar by looking at a P&F chart. 

These charts are useful as they give an idea of the potential strength of the move. They are not guaranteed by any means but it is uncanny how often they are proved right, and in conjunction with other analysis they can be extremely helpful. In the last two bars of the chart we can see the price move down to the 94 level, then the powerful bounce up to 103. If we look to the top of the chart we can also see the Bullish Chart Objective which is the level the rally could potentially reach.

These charts, together with the fundamentals suggest that the dollar rally has an awful long way to go. Which leads on to the next question, which is, once all this money moves into US Dollars, where will it be invested?

Again, fundamentally within the US there are only two markets big enough to cope with a massive influx of funds, the bond market and the equity market. Bonds have seen a surge of safe haven buying which is the usual dynamic in times of panic. The US bond market is still seen as the safest place on the planet in times of trouble. However, these bonds are now yielding virtually nothing. Even locking your money up for 10 years will get you less than 1%! These are ludicrously low yields and institutions simply cannot stay invested in them for any period of time as they need a better return on their capital. Once the absolute panic subsides, they will be desperate to find better returns, which leads us nicely to the only game in town..........the stock market.

So now that we understand why the stock market will rally once we pass peak fear, let’s turn our attention to whether now is the right time to dip our toe. 

In short..............Is there enough blood in the streets?

Lets take a look at the Dow Jones index to see where we stand.

We can see the two lines of support between the 17000 and 18000 area, and the major support at the 15000 area. This is also where the 200 day moving average currently resides. Looking at the technical indicators we can see the 14 day RSI at the top just about to enter the oversold zone, and the shorter term 3 day RSI at the bottom well into the oversold zone (As a reference, we would need to go back to 2009 for the last time these indicators were that oversold).

As I’ve already mentioned, we have been witnessing mass liquidations by funds desperate for cash, and as I don’t think we are at peak fear yet surrounding the COVID-19 end game, there may be a little more downside to come. We could well see a flush out panic low going all the way to the 15000 mark, however I think this would be extremely short lived and difficult to actually trade. My view is that anything bought between the 18000 to 15000 zone presents a great long term buy so there is no need to try to finesse it too much.

To be clear, I firmly believe that the market will be back up to the highs within a year and will then push on to new all time highs.

Other equity markets around the globe will likely be pulled up with the Dow but to varying degrees, and the advantage to all non US dollar denominated investors of being invested in the US Equity market is that you will get both the currency appreciation from a rising US Dollar as well as the benefit from a rising stock market.

Lastly lets take a look at the precious metals and see how they are faring.

Gold had been trading strongly through early 2020, continuing an uptrend from the $1045 low back in 2015. In fact, as the COVID-19 crisis unfolded it continued to gather support, bolstered by its traditional safe haven status, reaching a high of $1704 only a couple of weeks ago. However it was also looking extremely overbought and ripe for a correction. Unsurprisingly, also during this period, the commercials (professionals) were expanding their short positions and selling into this rising market. We have seen a number of times in the past that when the commercials build up a big position it serves to pay attention.

We can see from this chart of the Commitment of Traders that the commercials had their biggest short position of the year when gold finally started to crack, and even with the fall in the gold price, they still have a very large short position, suggesting that there is a lot more downside.

If we look at Silver by comparison, it has been absolutely thumped.

It too had rallied from the lows of late 2015 but never as enthusiastically as gold. Its COT figures were even more impressive than gold with a huge short position, and during this panic it has been hammered down to new lows. 

The precious metals shares have unsurprisingly also suffered some major falls as we can see in this chart of the GDX, an index of precious metal companies.

There are some reasons to think that the precious metals have bottomed. With the exception of gold itself, silver and the miners have been hit hard and the charts are in oversold territory. However there are a few things nagging me. 

1. Firstly, it feels like gold has benefited from a safe haven status (this is not surprising) and that some of that still needs to be washed out.
2.  The panic is not over yet, and forced liquidations should affect gold the same as everything else.
3. The COT positions are still bearish despite some improvement.
4. Despite being oversold, the technical indicators are not severely oversold which I would would expect to see at a major bottom.
5. The 2015 low. It never felt like a true bottom to me. There just wasn't enough panic and liquidation for my liking. I may be wrong and we may not reach those levels on this move, but before going long I definitely want to see more downside, and I think the US dollar rally might be the trigger that causes it.

For the time being I'm happy to watch and wait with respect to the precious metals.

Overall, this panic will throw up some fantastic buying opportunities, but it's one thing to recognize them, it's quite another to actually trade when every bone in your body is telling you not too. Ultimately that's what separates the true trader from everyone else.

Sometimes you just have to hold your nose and jump.