Covid19 Marketview

I'm taking the opportunity to think about the future and while I may not be the most qualified / knowledgeable, I think it's good practice to think about such things and pen them down anyway.

TLDR: I think the worst is still ahead of us, and currently the market is not pricing in the full potential effect of this crisis on the economy.


22 Mar 2020


  • Buy US equities later, prices expected to drop further
  • Buy those with a previous strong run, dominance in space, established, but haven taken a good hit
  • EM like India = Hold, China = Hold
  • Oil exposure ok to hold


Will US lose its dominance?

Considering the possibilities of a world power shift.

China is in a good position because they have had the backdrop of having that economic clout, and now they are recovering faster than US. But the world system is still quite entrenched, so I think it will take more than just this slowdown and who is faster to the recovery race to overthrow US. It will take a really crippling thing to happen to the US which renders their systems unusable and forcing the incumbent ‘clients’ to switch. Similar to how UK lost its dominance in WW2, US fortuitously gained. It was nothing UK could do. But that alone didn’t do it – it required a surge of innovation in the US to propel it forward.

So maybe this crisis is not enough. But it could be the start of something.

Maybe China will gain grounds it would never have the chance to gain until now. Not sure where though. It could further consolidate its power in being the engines of the world economy by looking to replace other links in supply chains that are now closed (because they were in Europe). Availability in a desperate time is valuable. It’s just too difficult to predict how, where, and to what magnitude this will happen.

Back to the question, I don’t think it will lose its dominance in the tech space nor will its stock market be left in the doldrums as the rest of the world accelerates. I do believe that the main indices will recover and make new ATHs in a matter of 5 years. That’s because this virus changes economic demand, and that is a temporary thing. It is not paradigm-altering. Consumer demand remains the same – people will still buy the same things after the crisis and use the same services.

I don’t think it will lose its dominance, though I do think that China will close the gap.


What are the prospects for emerging countries?

A year or a few years back, it was still a good thing to have because everything else in developed markets were expensive – i.e. both stocks and bonds, and we were hungry for yield. We have been since 2016 actually, leading to things like VIX apocalypse.

But now why would we bother with emerging economies when the developed ones are on discount? Looking at India vs US, both are down about 30% and so the relative value goes to US in terms of risk-reward. I doubt India can recover faster than the US.

China looks good given the above reasons, but it has only declined about 12% throughout this crisis, so in comparison to US it’s less of a priority.

I’m just going to keep IN and CN on a hold for now.


What’s the plan for loading up?

I expect this downturn to go further because the curve is just starting for US and probably in the middle or about 35% for Europe. Meaning there’s still some way to go which will really put a dampener on consumer demand and prices should reflect that accordingly.

It seems so far that the way the infection spreads is quite uniform in terms of trend in countries, so it’s not unreasonable to expect the same waves to occur in Europe then US.

Depending on how forward-looking the market is, these could have ALREADY been priced in at this -30% level. But only time will tell as the waves materialize whether the above is true i.e. if it’s not priced in then we’ll see further declines as the infections materialize. If it is already priced in, I expect to see some form of a bottom being carved out. Seeing a bounce in the midst of the wave could be something else (random optimism or some behaviour I really can’t explain) because I’ve yet to see a market so efficiently forward-looking.

Again, many market moves cannot be fully explained – I’ve been stumped quite a few times post-move even with the benefit of hindsight and a plethora of news attempting to explain things i.e. the explanations don’t make sense but more commonly no explanation is given “stocks move higher despite XXX” kind of rubbish headlines.


What to buy in US?

Major indices and tech companies. Generally, companies that have been solidly established and have further room to go but have been knocked back by this. Dominating tech companies are good buys to me, at these levels, as these will not be going away anytime soon. They also have the ability to tide through the storm.

Avoid stocks which are discount on discounts – i.e. prices have been falling anyway. A simple filter is to look for 10-year annualized total return and compare that against 1-mth or 2-mth change in price. With filter of some market cap.


What about oil?

I was a bit too hasty in getting into oil when it collapsed. It took one more hit from 30 to low 20s, which is my lower end of my range i.e. I really did not think it would get this bad.  I had underestimated the contango also – meaning I cannot roll over my positions without significant cost.

Though I think oil will rise back to more normal levels of $30, there is no way to play this as it is already priced that way for the Dec contracts.

Date USO WTI chg chg beta
Jun-14 38 106
Feb-16 8 36 -79% -66% 1.20
Sep-18 16 75 100% 108% 0.92
Mar-20 5 23 -69% -69% 0.99


USO looks decent though in riding spot oil. The contango is built in but at least that’s managed for me.

Funny thing about contango is that market is usually pretty correct – after sharp declines, further months are priced to a premium, and at peaks, they are priced to discount.

This is a reliable signal for the F1-F6 premium too.

What to buy in this recession

Just a quick thought - the last recession saw many financial institutions pulled under. But they were too important to the system, and so many never actually went away. Similarly in this crisis, perhaps we should be looking at the hardest hit sectors and ask: are their share prices reflecting the long term prospects accurately? I will be looking out for 'systemically important' hospitality / travel related companies that have been dragged down too much. It's only a matter of time before consumer demand, air travel, and mass events return. Like banks, they can never go away - they are too important, at least for this era.

Similarly, it would be interesting to see a repeat of 2008 in another sector - i.e. a major hospitality company fails and triggers bankruptcies and selloffs in other related companies and then spread to other less related companies.

Opportunities in the Outbreak

While it's certainly no good thing that outbreaks occur time to time, the volatility that it induces in the markets produces opportunities that are quite rare (thankfully).

The first phase is an asymmetric play - to buy the medical / healthcare stocks. They may suffer a bit if the outbreak is less contagious than expected, but they may be lifted by the more general relief going back into the broader stock market.

The thing with exponential growth is that we hardly grasp / estimate it well - we are usually shocked by the numbers when it materializes. Hopefully (and it is my personal view that it won't) materialize as per the trend.

I do expect the trend to buck soon, and when it does, then phase 2 of the plan will be to exit phase 1 and get exposure in the beaten down stocks e.g. airlines, hospitality etc. probably by selling puts, trying to catch a falling knife with the hopes that the signal above is a strong enough and reliable one that we are about to turn the corner.

But above all I do hope for the safety and health of people. It's one of those things you don't mind losing money in a trade for.

Update on 19 Feb

The asymmetric trade in phase 1 did not play out - so that's a small loss, but I went in a bit early on phase 2 and managed to buy some things cheaper. Of note was some stocks which had very high implied vols, and I shorted some puts.

Brexit No Deal – Custom Payoff Strategy

Here we look at constructing a customized payoff for this event.

Betting site odds are 7/1 for No Deal: Bet $1000 on No Deal

Buy ATM GBPUSD Call for $2000 at strike 1.2650 (spot is at 1.2640) - breakeven is at 1.2850 which is 1.7% up (if including loss from bet, 1.2950, which is 2.5% up)

Deal No Deal
GBP up -1000 from Bet

+ ??? from Call

Net > -1000

+7000 from Bet

+ ??? from Call

Net > +7000

GBP down -1000 from Bet

-2000 from Call

Net -3000

+7000 from Bet

-2000 from Call

Net +5000

Limited risk payoff with maximum downside of -$3000

Assign probabilities into the 4 scenarios to get expected value, example:

Deal No Deal
GBP up 70% 5%
GBP down 5% 20%

Unfortunately, I think that when the Deal scenario plays out, the GBP will not rise enough to cover the cost of the bet and the premium paid.

Also, I don't have access to online betting sites, so this will only remain a theoretical trade.

Trading the Inverted Yield Curve (Part 2)

Following up from Part 1, I'd now suggest that STPP ETN could be the most hassle-free candidate to trade the inverted yield curve, but take note of its expiry date (13 August 2020). STPU ETF is another candidate, but the data points are too few to assess if it would have good tracking. We can possibly first trade the STPP and then "roll" it over to STPU nearing expiry.

The risk I'd like to address here is transmission risk - risk that the trade vehicle does not deliver on its expected results. We might get the call right, but if the vehicle gives poor tracking, it'll be a shame.

Make your own assessment and take the trade according to your risk appetite. For me, it's more for fun because these come only once a decade or so.


Is this time different?

First we have to get a sense of what are the likely scenarios in the next 1-2 years:

Recession - this should give us the best outcome on the steepening bet as the near yields would decline faster than the far yields.

No recession - the 2YR and 10YR rates would likely peg each other closely like in 1995-2001, and we need to wait for the next recession to trigger the steepener.

The major phases can be summarized as such:

< 1990 No clear trend in spreads
1990 - 1992 Yields falling, spread widens Recession
1993 - 1995 Yields rising, spread slowly narrows Expansion
1995 - 2000 Spread continues to slowly narrow Rates fluctuate, expansion
2001 - 2003 Yields falling, spread widens Recession
2004 - 2007 Yields rising, spread narrows Expansion
2008 - 2011 Yields falling, spread widens Recession
> 2011 Yields flat / slowly rising, spread narrows Expansion

There is a good amount of similarity between the 1993-2000 phase and the current phase in that both feature strong, prolonged bull markets and a slowly declining yield spread.

In addition, the instance in 1995 where the spread is near 0 and then both of the rates go lower in sync is very similar to what is happening right now. In that line, what may occur next is a prolonged wait before the steeepening occurs.


How good is STPP for tracking?

The rolling beta is too choppy for any use, so instead we will look at major inflection points on the 2YR-10YR Spread, and focusing on the dates from when the STPP is available.

The drag effect that you see is not so much due to STPP as it is due to the index that it attempts to track. The index does not do too good a job in tracking the spread. As stated on the website:

"Reasons why this might occur include: market prices for underlying U.S. Treasury bond futures contracts may not capture precisely the underlying changes in the U.S. Treasury yield curve; the index calculation methodology uses approximation; and the underlying U.S. Treasury bond weighting is rebalanced monthly."

The beta (sensitivity of the STPP price to the yield spread) can vary quite widely. It's a crude measure, but gives a ballpark figure of what we can expect. The effect seems a bit asymmetrical - down moves are of a higher beta - which is not good. Also note the small recent uptick in spread did not translate to any gains in the price - in fact, price went down slightly.

However, note that we are only looking at fractals of one leg of the cycle. These intermittent fluctuations could well be overwhelmed (in a favourable way) in the next major leg up.

Of course, the it could also be that the leg up of the cycle suffers from the low beta problem as well. Which direction, I'm uncertain, but it may not matter that much.

Below are 20-day and 60-day correlations on the values and on the daily % change in prices. Again, this is a more granular detail which I believe will be flushed away with the tide on the next leg up. The minor concern here is that the correlations can be zero or negative at some points in time, despite giving it a 60-day period (3 months).


Targets and stops

From the first chart, we can reasonably expect the spread (when it steepens) to return to previous historical levels of 2.0 to 2.5.

The mechanics of the pricing is not easy to estimate because of the way it's structured - the index multiplier and the monthly rebalancing.

A simplistic assumption of the STPP price would be for it to return to its $40+ level - where it coincided with the 2.5 spread level.

The spread could go to -0.5 as per previous inversions, or worse but unlikely to -2.5. This might roughly translate to a price of $20 and $0.


Continue reading "Trading the Inverted Yield Curve (Part 2)"