The Corona Spread

“There is nothing to fear, but fear itself.” Guess who said that?

Similar to 9/11 and the Patriot act that followed, the biggest damage being done is by governments and people overreacting. However, in this article I would like to purely focus on financial markets. At the beginning of the virus outbreak markets largely ignored potential risks. Now, an overshooting in the other direction looks likely. Such excessive moves warrant further analysis.

We focus here on the extremes in the German market which are symptomatic for what is happening in equity markets around the world. We built two baskets from the highest market capitalization stocks in Germany (DAX and MDAX constituents). The top 10 most directly hit companies constitute our SHORT basket (e.g travel, semis, autos), while the LONG basket consists of relative winners of the crisis (e.g. health care, home delivery, security). The baskets were equal-weighted with an exception in the SHORT basket: we took 12 stocks and half-weighted the 4 auto stocks so that in sum they constitute 2 of the 10 stocks. We then divided this year’s performance into three phases: up to the market high on Feb 17, the ensuing crash week, and last week. Here are the results in comparison to the DAX:

Besides the obvious almost 30% spread over the 10-week period between the LONG- and SHORT-basket, there are some additional interesting observations:

• The long-short spread already opened up while the market was still rising, with the short basket actually falling in a rising market.

• As often happens in sharp and fast downward moves in the market, everything falls as correlations among stocks approaches 1. Therefore, the long basket was also hit hard in the initial “crash”-week.

• Finally, in this last week where markets were down again, the long basket gained significantly.

In general, one has to be careful in terms of acting on such observations. Finding extremes in performance, valuation, positioning or other factors is only a first step. In the next step, you need to analyse the underlying causes and determine whether they will persist into the future.

My preliminary assessment of the SHORT basket is that it is too late to short, but too early to buy. The real work has to be done on a company by company basis. For example, steel/industrial conglomerate, ThyssenKrupp fell 10% up to Feb 17, then20% in the crash week and last week almost another 20%. Its stock now trades at about half its cash value after its recent elevator divestiture. Value investors have to be licking their fingers in anticipation, but most investors still think it is the easy short given its poor past managerial performance.

Let’s focus now on some general investing conclusions. Clearly such a large spread invites the rubber band effect as soon as some of the panic recedes. The only risk of a strategy trading the reversal by going long the SHORT basket and vice versa is that elastic bands occasionally break. Then we may get what is now fashionable called a black swan. A crash of another -10 to 20% (or more) downside could happen if a full blown global recession develops.

Another approach would be to buy unjustified relative losers. For example, in the small/midcap space there are a number of clear relative beneficiaries of the COVID19 crisis that nonetheless dropped more than the DAX because of de-risking on the part of traditional fund managers.

In conclusion, it will be key to stay flexible, stay alert, and have patience, then pounce with determination: greetings from the seaeagle!

The HanseaticHunter