Traders, some in medical masks, work on the floor of the New York Stock Exchange in New York City. Photo: AFP

US equities traced more than half of their Friday losses led by healthcare, consumer staples and tech monopolies like Microsoft and Facebook. Massive intervention by the Federal Reserve and the European Central Bank brought down most – but not all – credit spreads. The US dollar fell after last week’s jump due to a global shortage of the US currency. The S&P’s closely-watched volatility index, or VIX, receded a bit. 

All these are encouraging signs, but aftershocks still could strike the market. Equity investors are buying stocks with strong underlying cash flows and limited debt, and selling sectors with high debt and exposure to a seize-up of the US economy. I continue to believe (as I argued March 14) that the market presents selective buying opportunities, although investors should beware of stocks with too much dependence on leverage.

The worst performers were oil and gas producers – no surprise with energy prices in free fall – and Real Estate Investment Trusts of all categories. Residential REITs, once considered bulletproof, lost 5% while the overall market rose by more than 2%, as investors weighed the impact of mass layoffs on rent collections. Consumers will buy medicine, disinfectant and staple foods before they pay rent, so the outcome is rational. 

The Federal Reserve’s promise last week to make unlimited purchases of Treasury, mortgage, investment-grade credit and municipal securities  helped a lot – but not quite enough. The cost of a year’s credit insurance on a broad basket of investment-grade bonds today cost 112 basis points (hundredths of a percentage point), better than the 151 basis points on March 20 but much higher than the 44 basis points on February 13.

The spread between Treasuries and US agency-backed mortgage securities, though, has come in from a high of 171 basis points to 90 basis points, in the middle of its pre-crisis trading range. The yield on 10-year Treasury Inflation Protected Securities has swung a full 100 basis points, from +0.6% to -0.4%, in less two weeks, as investors first fled the Treasury market in the advent of an avalanche of new issuance, and the Federal Reserve then bought whatever was available for sale. The Fed’s balance sheet had ballooned by more than $1 trillion in the week ended last Wednesday and the eating-contest continues.

The one risk parameter that has not retreated is the spread between high-quality commercial paper and US Treasury bills. It rose today to 2.4 percentage points, from zero before the crisis. In 2008 it briefly touched 3.8%. The Fed simply hasn’t thrown enough resources into the market to allay the fears of investors who are fleeing money market funds for the safety of Treasury bills.

Uncertainty remains extremely high, much higher by one measure than in 2008-2009. It’s helpful to look at the price of hedging the S&P compared to the size of daily percentage changes in the S&P. There is a close relationship between daily changes in the S&P and changes in the VIX Index of the normalized cost (“implied volatility”) of option hedges on the S&P. During the past dozen years, daily changes in the S&P explain about 70% of changes in VIX.

The chart above shows the level of VIX one would expect to see given the actual changes in the S&P 500 (on the horizontal scale) against the actual level of VIX (on the vertical scale). The steeper the slope (or beta), the more sensitive the actual VIX is to movements in the S&P. We have had three periods of extreme moves in the VIX  in September 2008, March 2009, and March 2020. The slope, or sensitivity, of VIX during the past month was far steeper than in the past. That’s a rough-and-ready measurement of the market’s degree of uncertainty.

The good news today is that the actual level of VIX, at about 60%, was about the same as the model’s forecast of where it should be given changes in the S&P. That’s a sign of normalization. Sophisticated investors might consider buying put options on VIX in anticipation of more normalization down the road.