16 March 2020

The S&P 500's Increasingly Volatile Roller Coaster Ride

You can't say you weren't warned. The erosion of expected future dividends through the projected future of 2020 has begun contributing to the increasing volatile roller coaster ride S&P 500 investors have found themselves on.

Although we've been attaching daily updates of the market's actions to our regular weekly S&P 500 chaos series' posts, we thought it might be a good time to fully review the S&P 500's latest Lévy flight event, which took place between 24 February and 9 March 2020, as investors fully shifted their forward-looking attention from 2020-Q4 inward to 2020-Q2. The following animation shows all the market's action over the last three weeks from Friday, 21 February 2020 through Friday, 13 March 2020.

Animation: Alternative Futures - S&P 500 - 2020Q1 - Standard Model - Snapshots from 21 February 2020 through 13 March 2020

The Lévy flight event is really associated with changes in the expected timing of rate cuts by the Federal Reserve, where investors went from expecting two quarter point rate cuts in 2020, one in 2020-Q3 and another in 2020-Q4, to where as of last Friday, they are expecting the Fed to slash interest rates on or by the conclusion of the Federal Open Market Committee's 18 March 2020 meeting to the zero bound, which is to say to a target range between 0% and 0.25%.

In between, there was an emergency rate cut of a half point on Tuesday, 3 March 2020, and as of yesterday, Sunday, 15 March 2020, the Fed has executed another emergency rate cut, this time to the zero bound.

Since that expectation had locked in as of Wednesday, 11 March 2020, which brings us to what happened on Thursday, 12 March 2020, when the bottom seemed to drop out of the S&P 500. This is where the erosion of future expected dividends caught up to the level of the S&P 500, causing it to prematurely plunge by nearly 10%, which is to say it moved to the level it descended earlier than the dividend futures-based model anticipated.

We think that's a contributing factor to why the S&P 500 rebounded so strongly on Friday, 13 March 2020 when President Trump announced the government would be turning to the private sector of the U.S. economy for assistance in combating the coronavirus pandemic.

And that's pretty much what happened during the crazy week that was for the S&P 500. Since the Fed has already acted to slash the Federal Funds Rate to the zero bound range, we'll dispense with updating our snapshots of the CME Group's FedWatch tool's indicated probabilities of expected changes in that interest rate, and instead animate how investor expectations for future S&P 500 dividends has changed over the last three weeks, matching the period covered in our animation of the S&P 500's roller coaster ride.

Animation: Past and Projected S&P 500 Quarterly Dividend Per Share Futures from 2019Q1 through 2020Q4, Snapshots from 21 February 2020 through 13 March 2020

We'll also provide a more complete listing of previous week's market-moving news headlines than what we have in our daily updates:

Monday, 9 March 2020
Tuesday, 10 March 2020
Wednesday, 11 March 2020
Thursday, 12 March 2020
Friday, 13 March 2020

Over at the Big Picture, Barry Ritholtz listed the positives and negatives he found in the past week's economics and market-related news.

While the S&P 500's volatility remains elevated, we'll attach daily updates of the market's main actions after the end of each trading day until it somewhat settles down. If you're accessing this article on a site the republishes our RSS news feed, you can get the latest updates by clicking through to the original article on our site. The best time to check will be late in the evenings, but since we don't follow a set schedule in posting updates, you might more reliably find our updates early the next morning.

Inside The Second Biggest Ever Percentage Loss For The S&P 500

Update 16 March 2020, 10:30 PM Eastern: The S&P 500 dropped 11.98%, the second biggest daily decline ever recorded by the index since Standard & Poor expanded its existing S&P 90 index to include the 500 largest publicly-traded U.S. firms back in 1957. Today's decline to an index value of 2,386.13 ranks only behind the infamous Black Monday Crash of 1987, which saw the value of the S&P 500 drop by 20.47% in a single day. Here's what the new drop looks like on the alternative futures forecast chart for the index:

Alternative Futures - S&P 500 - 2020Q1 - Standard Model - Snapshot 16 March 2020

We can dispense with presenting updates to the CME Group's FedWatch Tool's probabilities for future changes in the Federal Funds Rate and S&P 500 quarterly dividend futures in this update. With the Fed having slashed rates to a target range of 0%-0.25% yesterday, the CME Group's analysts will need to rework the tool to accommodate the possibility of negative rate cuts. At the same time, there was no change from Friday, 13 March 2020 for the S&P 500's quarterly dividend futures, so there's simply no update to present on that count!

Before we go further in analyzing the day's events, let's establish a definition for what stock prices are. In a well-established market where investors are largely free to voluntarily engage in transactions within it, stock prices represent the approximate present value of the dividends that investors reasonably expect to be sustained at specific points of time in the future.

In setting current day stock prices, let's say that investors start with the assumption that the future will be like the past, which makes the current day's stock price the starting point from which changes in future expectations, and thus stock prices themselves, will be adjusted with respect to. Once that starting point has been established, the rest of how stock prices behave turns out to be a relatively simple problem in what could be described as quantum kinematics. It's complex, but this approach makes it relatively easy to project where stock prices will go in the future if you can sort out how far forward in time investors are looking into the future in establishing their expectations as they set current day stock prices. According to the alternative futures chart, they still look to be focusing on 2020-Q2.

The reason we're bringing this definition up is because there's evidence that a major cause of the market's recent disruptive events is the failure of the Fed and other central banks to address a major portion of a developing liquidity crisis in the global economy, which is to say the market is having trouble with the "well-established" part of the definition. Specifically, when the Fed and other national central banks fired their emergency monetary policy bazookas on Sunday, 15 March 2020, we think they were aiming at the wrong liquidity problem, which is why the S&P 500 has prematurely collapsed to this level despite their action, at least according to the dividend futures-based model that helps explain why stock prices have been behaving as they have and has anticipated most of the volatility the S&P 500 has experienced.

What could the Fed do better? Right now, with major firms like Boeing, Kraft-Heinz and others looking to draw down as much cash as they can from their lines of credit as they respond to the coronavirus pandemic's impact on their businesses, we have the equivalent of a proverbial run on the bank, only it is huge corporations facing dismal outlooks engaged in the run. In their coordinated action, the Fed and other national central banks failed to provide liquidity support for the corporate paper (or debt) market, which is negatively impacting investor assessments of these firms' ability to pay dividends in the future.

That assessment lowers the projected future for stock prices regardless of how far forward in time you look, but more importantly, it is at the same time also lowering the starting point from which the potential future trajectories of stock prices are set. Like the coronavirus pandemic itself, it is the effect of a cascading failure, which is the result of an adverse feedback loop.

Much as the public is being tasked with engaging in quarantine practices to slow the spread of the COVID-19 pandemic, the Fed can stage an effective economic intervention and keep the big dominoes from falling by providing liquidity support to corporations, sufficient to ensure they can sustain their planned dividend payments more than a year into the future. Their focus should be on stopping the erosion that is taking place in the expectations for future dividends, which will provide the positive acceleration needed for stock prices to reverse their current crash trajectory. Done right, this action could lead investors to focus on a point of time further out into the future than 2020-Q2 which will help take much of the downward pressure off stock prices and allow the Fed to focus on other trouble areas.

It's not the only liquidity-related problem they need to address, but what we've described is an immediate action they can take that would produce positive visible results that would help restore a measure of their credibility. That's important because if people increasingly distrust those institutions, then the risk of a cascading failure grows, because the interventions that might otherwise be effective in arresting a series of failures after they have begun would be rendered impotent. If you know anyone at the Fed, please forward this suggestion to them.

The St. Patrick's Day Dividend Futures Massacre

Update 17 March 2020, 10:00 PM Eastern: The S&P 500 rebounded by 6% to a level of 2,529.19, thanks largely to the Fed initiating a short-term funding plan to support liquidity in the commercial paper market, plus news of a growing fiscal stimulus bill being advocated by the Trump administration on Capitol Hill. Here's what the latest update to the alternative futures chart looks like through the close of trading on St. Patrick's Day 2020:

Alternative Futures - S&P 500 - 2020Q1 - Standard Model - Snapshot 17 March 2020

The S&P 500 is no longer "early" in reaching its current level, because the projected trajectories of the dividend futures-based model has caught up to the level at which stock prices closed on 17 March 2020.

That is partly due to the sugar boost of the 6% rally in the S&P 500, but is mostly due to a collapse in the expectations for future dividends, which plunged on 17 March 2020.

Past and Projected Quarterly Dividends per Share for the S&P 500, 2019-Q1 through 2020-Q4, Snapshot on 17 March 2020

We think both actions are attributable to what the Fed did with its liquidity support for the commercial paper market. Stock prices rose as anticipated on the news the Fed was going to reactivate its 2008-era CPFF liquidity support program for the commercial paper market, but dividend futures crashed because the amount of support the Fed can provide through this facility will fall far short of providing the magnitude of liquidity that a growing number of distressed companies desperate for cash will need to stay afloat without realizing massive reductions in their costs of operations, including large scale layoffs. Today's decline in expected future dividends is a harbinger for these other more severe outcomes for firms that will become completely starved for cash in the weeks and months ahead.

Credit Suisse's Zoltan Pozsar describes the commitment the Fed will need to make to avoid these outcomes.

The breakdown of o/n repo markets yesterday tell us that balance sheet is now getting scarce to conduct even the most basic type of market making.

As banks are pulling back from market making, the Fed and other central banks need to assume the role of dealer of last resort...

The Fed needs to become a buyer of CDs and CP, but not through the CPFF. The Fed needs to offer dollars on a daily frequency through the swap lines, and other central banks need to lend dollars on to both banks and non-banks.

The Fed needs to broaden access to the swap lines to other jurisdictions as dollar funding needs are large in Scandinavia, Southeast Asia, Australia and South America, not just in the G-7.

The dollar funding needs of both banks and non-banks is what’s at risk and the assets that are being funded are U.S. assets – Treasuries, MBS and credit – so the Fed has a vested interest.

The Fed still might come through, but doing so will mean doing far more than it has considered to date. The window of time they have to decisively act to forestall more disruptive events however is running out. We will soon be on the cusp of large numbers of dividend cut announcements, which will precede and coincide with other more severe outcomes as what is now a developing cascade failure propagates through the global economy. What kind of consequences do you suppose the Fed is willing to live with?

The Decline Resumes As Access To Cash Becomes Imperative

Update 18 March 2020 5:30 PM Eastern: Just over four weeks ago, on 19 February 2020, the S&P 500 reached a record high value of 3,386.15. Through the close of trading on 18 March 2020, it now stands at 2,398.10, having lost 988 points, or over 29% of its value. All of it attributable to events related to the global coronavirus pandemic, and the responses to it that are curtailing economic activities, and the damage that is doing to the industries that are very dependent on cash from revenues to keep their operations alive.

We've reached the point where we've had to re-draw our charts to accommodate much lower forecasts for stock prices and dividends. The alternative futures chart is first, where we find the level of the S&P 500 is most closely aligned with the trajectory corresponding to investors focusing on 2020-Q4 and the expectations for dividends associated with that quarter.

Alternative Futures - S&P 500 - 2020Q1 - Standard Model - Snapshot 18 March 2020

At this point, it's a very good thing that investors aren't yet looking at 2020-Q1. Speaking of which, in addition to adjusting the vertical scale of the dividend futures chart, we've also added 2020-Q1 to it in this latest update.

Past and Projected Quarterly Dividends per Share for the S&P 500, 2019-Q1 through 2021-Q1, Snapshot on 18 March 2020

On 19 February 2020, investors were expecting the S&P 500's quarterly dividends in 2021-Q1 to be $15.65 per share. On 18 March 2020, that has fallen to $9.50 per share, a 40% decline. Restoring business' access to cash to sustain their operations will be key to stabilizing stock prices - there's still time, since most firms haven't slashed their dividends yet, but if the expectations for dividends in this quarter can be improved, say by a central bank providing sufficient cash liquidity to businesses, the action would put a floor in under stock prices.

Positive Developments Outweigh Negative For A Change

Update 19 March 2020, 9:30 PM Eastern: Positive developments outweighed the negative for the first time in days, as the S&P 500 closed up nearly a half percent to close the day at 2,409.39.

There were two big positive developments to outweigh the news of dividend cuts and impending layoffs for the day. First, the ECB's minions finally stepped off the sidelines and finally acted to begin providing liquidity to cash-starved Euro zone markets. Second, the Fed took a more serious step toward boosting the liquidity of U.S. money markets. In our view, both institutions will need to do much, much more, but what they did today took a good portion of downward pressure off stock prices, which isn't an insignificant result.

Investors responded to the news by shifting their attention back toward 2020-Q2, which thanks to the recent erosion of dividend futures in distant future quarters, represents a more desirable trajectory for the S&P 500 if their attention can be fixed there.

Alternative Futures - S&P 500 - 2020Q1 - Standard Model - Snapshot 19 March 2020

That shift in focus toward 2020-Q2 was a very positive development, because expectations for S&P 500 dividends per share in 2020-Q3 and 2020-Q4 have continued to deteriorate. Had investors focused on 2020-Q4, for example, stock prices would have continued their steep decline. The following chart updates the expectations for S&P 500 quarterly dividend futures:

Past and Projected Quarterly Dividends per Share for the S&P 500, 2019-Q1 through 2021-Q1, Snapshot on 19 March 2020

On the whole, the dividend futures based model has done extraordinarily well in both anticipating and explaining the trajectory of stock prices during the coronavirus pandemic crisis. That's not surprising for us, since we developed the math behind it during late 2008 and early 2009, when the market experienced a similar magnitude disruptive event.

We'll recap Friday's market action on Monday, and continue appending daily updates to that post as we see what the never ending stream of new information brings in the next week.

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