19 October 2020





DOES THE STOCK MARKET FEEL WEIRD TO YOU? THIS MAY BE WHY




By Raul Elizalde

This article also appeared on forbes.com


Correlation among equity sectors has been low since the market crash in March. This is odd because market crashes cause a lot of insecurity among investors, who then start to buy or sell the market as a whole, which pushes sector correlation up. This is not happening this time.


One of the likely reasons why the market is not behaving as in previous post-crash periods is that a huge amount of money was injected into the system very quickly and inefficiently, leaving a lot of surplus liquidity available for investment. Also, the fact that the recession was caused primarily by a pandemic rather than by a downturn of the economic cycle makes it difficult to draw a parallel between the current crisis and previous ones. As such, the market is behaving in unfamiliar ways.


One would have expected that in the wake of the crash, risky assets would go into a “risk-on, risk-off” regime, meaning that people swing between optimism when the news is good (and so they buy), and pessimism when the news is bad (and so they sell). This is what usually happens after a crisis, when investors believe that whatever caused it may still be unresolved and therefore leaves them unwilling to commit to more nuanced allocation decisions other than buying or selling the market as a whole.


Looking at how U.S. equity sector ETFs behaved after the 2000-2002 bear market and the 2008-2009 financial crisis we see this “risk-on, risk-off” pattern as sectors moved close together for many months after the respective market bottoms, as the two graphs below show:

source: Federal Reserve Bank of San Francisco


source: Federal Reserve Bank of San Francisco
Following the pandemic-induced crash, however, the divergence between the best- and worst-performing sector ETFs has been much wider than in the previous two major crises.

source: Federal Reserve Bank of San Francisco
Because uncertainty today is very high – a pandemic, U.S. elections, erratic stimulus talks, etc. – a reason for the low correlation cannot be simply that people have a clear vision of the future. Instead, a more likely explanation is that large amounts of liquidity that leaked from the inefficient delivery of government stimulus went to investors’ cash balances and from there to stocks.


Liquidity was brought up quickly after the initial crisis through a combination of stimulus checks, emergency loans and bond purchases by the Fed. Not all of it went where it was needed, and much of the excess cash was invested in the equity market. Investors don’t have any reason to expect that this is temporary. Not only the Fed has made it clear that it will conduct a loose monetary policy “for years”, but it also seems very likely that another round of fiscal stimulus will pour even more cash into investment portfolios, regardless of how difficult negotiations leading to that outcome appear today.


In addition to the liquidity reason, investors may be suspecting that the U.S. (and global) economy will be massively transformed in the post-pandemic world.


One example is the work-from-home trend, which could have huge implications for office buildings, furnishings, transportation and communications. This is best illustrated in the recent conference call with BlackRock, a giant asset manager with $8TN of customer funds. They noted that they “were able to very quickly migrate from 16,000 people in 60 offices to 16,000 people and 16,000 offices”, adding that “by and large, many large companies including BlackRock, have learned, yes, we can work remotely without much in terms of degradation of operational efficiencies.”


If investors are really anticipating that the economy is undergoing a fundamental transformation because of the pandemic, then the diverging sector performance after the crash of March makes sense: The technology-sector ETF (XLK) has gone through the roof while the energy-sector ETF (XLE) is in the gutter. Most likely, the low correlation among assets we observe today responds to both factors: the effect of today’s mountain of money and the expectation of tomorrow’s brave new world.


In the short term, however, it seems reasonable to expect that correlations and volatility will fall back in line, because the discrepancy is too large for historical standards. Either the market will resume its rally and break through previous highs, bringing volatility down in line with today’s low correlations, or it will take a turn for the worse, pushing up correlations in line with persistently high volatility. We think the former is more likely for various reasons, including the persistence of fiscal and monetary stimulus and the promise of a Covid-19 vaccine.


One thing seems certain, though: A vaccine will not bring back the world as we knew it. It would likely prop up asset prices, but the effects of the pandemic over the make-up of the economy and even over daily life may turn out to be much more profound that what meets the eye today. If so, investment strategies will also have to adapt to that new world.


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