I may be wrong, but I’m still bearish

The markets rallied significantly today with the S&P 500 up around 6.7% and the Russel 2000 up around 7.6%.  Here’s what’s going on…

Bull case – basic narrative:

The federal reserve has got your back.  They are pushing QE-infinity right now pushing out trillions into government bonds, investment grade corporate bonds, and even foreign currencies to backstop the dollar shortage with a number of foreign central banks.

At the same time, the government has pushed stimulus packages through including a lot of money to the corporate sector as even a bit extra to the recently unemployed.

The coronavirus lockdowns are expected to last until May at the latest, and then stocks will take off like a rocket with all that easy money from the federal reserve.

Bear case as I see it:

Worldwide lockdowns are bringing economies to a standstill.  Around the world, including in the US, unemployment is shooting up like crazy right now.  While the government stimulus will help to alleviate some of the pain, it won’t replace income to previous levels and demand will fall.  At the same time, huge sectors of the economy are at a virtual standstill including big-box retail, restaurants & bars, tourism and travel, automobiles, manufacturing, and more.  Many businesses that are shut down are making forbearance agreements or simply not paying their leases.  Many strapped workers – particularly in big cities with expensive apartments – will run low on cash and stop paying rent.

The federal reserve can only backstop investment grade debt … they can’t directly help with junk bonks or stocks.  Before this crisis, a record amount of borrowing to fund corporate stock buybacks took place pushing the market to all-time highs while also pushing the vast majority of businesses to just one notch above junk bond status.  As downgrades from lost earnings hit the system, many of these companies can be locked out of the credit markets.  Similarly, many small businesses are already unable to cope with the shutdown despite government efforts at pushing loans their way.  Many of these businesses will simply shut down or go through bankruptcy.

Two major forces that relentlessly push the stock market higher under normal circumstances are disappearing fast.  One of them is corporate buybacks … most corporations will need to preserve that capital to stay afloat.  Another one is money pumping into 401k’s and pension plans from wages.  This decreases as layoffs continue and people who keep their jobs decide to save more money in cash accounts in case they’ll need it.

Finally, I don’t expect that this pandemic will be over and done with in 2 short months (mid March to mid May).  Not only do I expect lockdowns to last a bit longer, but I expect that they will only reluctantly loosen up as threats of new outbreaks occur.  In addition, flu’s often happen in waves and many immunologists expect another potential wave in the fall.  Taking all that into account, it seems unlikely that May hits and the economy is back off to the races again.  Companies with jobs that can be done remotely will be hesitant to start forcing their workers to commute right away.  Travel, tourism, restaurant visits, driving, and many other activities will come back only slowly after lockdowns ease.

What I’m doing:

At first I purchased a number of puts in different companies – initially with an April expiration (I now expect to lose money on those, and have limit orders to sell at a small loss), and then going further out in duration as the rally continued further.  However, the premium can be expensive making it difficult to come out on the winning side with those bets.

Then I found that you can buy in-the-money puts for on the S&P 500 (specifically in the ETF ticker SPY) giving you positive exposure to almost the full downside of the S&P 500 at a relatively low price.  I put a significant amount of money in this, with contracts going all the way out to November.  I bought a number of these at the end of March, then added a bunch more today.

Now I’m thinking I have enough negative exposure to the S&P 500, but I still want to go short more if the rally continues.  I’m thinking I can do the same thing with puts in the ticker IWM which tracks the Russell 2000.  The advantage here is that the small caps don’t directly benefit from the largesse of the federal reserve, though they do have some government loan packages encouraging them to keep their employees on the payroll.  Also, you can buy in-the-money puts to get short exposure to the sector at a reasonable price, even going out to the end of the year.  These did drop a lot further than the S&P 500 large caps – being down 35% from the high vs 22% down on the S&P 500 – but they still rallied big off the lows.

I don’t expect that we’ll revisit the lows in the next 2 weeks, but I do think that when it happens it will happen fast, and it will likely be before the 2nd quarter ends in June.  At that time markets will have to price in a longer lockdown period (or a slower recovery), and the extent of the quarter’s economic damage will be visible.  Also, we haven’t hit the bulk of the crisis yet, and many states are still unaffected.  Once we start getting to the heart of the crisis, I expect the narrative of the quick recovery to change.

I could easily be wrong, but that’s a risk that a stock trader has to be willing to take.  Good luck and stay safe out there!


About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at gluskinsheff.com. Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
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1 Response to I may be wrong, but I’m still bearish

  1. Pingback: My trading scorecard: decisions traced through the pandemic | Market Thoughts – What I’m doing and why

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