One year ago was a truly frightening day. Mid-March of 2020 was one of the scariest times I can remember, on a par with the depths of 2008 and the 1987 crash. The S&P 500 (SPX) and Dow Jones (INDU) each fell about 12% on March 16^th, 2020. It was the worst fall in percentage terms since 1987, and the highly reported INDU fall was the largest ever in point terms. I would argue that the fears in 2020 may have actually been more visceral than those of the prior incidents.  In those cases, people were concerned only about their finances and livelihoods, while in 2020 they were concerned about their actual well-being. 

As in those early incidents, which would have been termed “The Panic of … (1987/2008/2020)” had they occurred 100 years earlier, there were real cracks in the market infrastructure that became exposed. In each of these cases, the cracks became fault lines, and those created real tremors in the system. Here are some of the lessons that we learned (and some that have already been forgotten):

•  Liquidity can evaporate, and it is especially dangerous when it evaporates when futures need to be rolled. It is no coincidence that March 16^th was the Monday prior to a quarterly expiration and that the eventual bottom was the Monday that followed. Investors use a wide range of trades to manage their risks in the days leading up to a quarterly expiration.  Traders and investors utilize futures for all sorts of hedging and investing purposes, and it is all but given that those futures can be rolled easily.  That was the week that they couldn’t be rolled. The only other time that I recall futures to be so illiquid was 1987 when investors were under the misapprehension that selling futures offered protection in a market decline (until everyone tried to do that and there were no bids). The 1987 crash was largely built on a false expectation of liquidity. The 2020 events were the result of normal expectations that were unexpectedly disrupted. 
• Problems metastasize in all sorts of strange ways. With roll activity hampered, all sorts of problems followed. If someone was short futures against a basket of stocks or ETF’s – a common trade – they faced the prospect of being grossly overexposed the following week when their short futures could expire with no replacement. That would incentivize them to sell the long stock position. Those who held futures and cash in lieu of index exposure through a basket of stocks found it difficult not only to roll their long exposure forward at a reasonable price, but they now had the added worry about the safety of their cash as well. Those who were short puts found themselves in a real bind – unable to sell stock short into a declining market and unable to purchase new protection at any price, let alone one that allowed them to avoid potentially catastrophic losses. Similar problems were faced by bond investors, who found liquidity evaporating and hedges exploding. 

• It is really hard to buy a parachute when there is turbulence.  Price discovery becomes very difficult when folks are concerned about return OF capital rather than return ON capital. A spike in VIX and an inverted VIX futures curve reflects a shortage of available protection. In this case, there was a multitude of investors and traders who either needed protection ASAP or desperately desired it. When markets are plunging and the normal providers of that protection are themselves facing an abyss, the protection is hard to come by. Volatility measures like VIX spike. When traders find themselves cornered – unable to see their way out of a potentially disastrous situation – price discipline goes out the window. How much are you willing to pay for protection when your career is at risk? Conversely, what is the right price to sell that protection when you have no clarity into what lies ahead? 

• The “Fed Put” is real, though I will argue the strike is a lot lower than where most people think. It wasn’t until the Fed called in the cavalry and brought out the heavy artillery that markets settled down somewhat. Markets later rallied when it became clear that the Fed would use all the resources at its disposal to protect the financial system, and rallied further when Congress joined in to help. As in the examples above, the lender of last resort fulfilled its obligations and played a key role in rescuing the US (and global) financial system. But think of the drawdowns that we saw before the Fed was able to staunch the bleeding. I certainly don’t think any central banker wants to see episodes that can threaten the system, and that true crises can get really nasty before the ship is righted.

• It’s easy to forget the lessons stated above. Futures and options rolls went on yesterday without a hitch, and I expect them to have no problems for the foreseeable future. That’s how the markets are supposed to work, and that is wonderful. But how many of those who are rolling their futures and options have given any consideration to the fact that it was nearly impossible to do that just a year ago? Other than grumpy “inflationista” bond traders and some stock traders who are half-worried about the effects of higher rates on tech valuations, who is truly concerned that the perfect storm of fiscal stimulus atop monetary accommodation amidst a naturally recovering economy might have undesirable or unanticipated consequences. And what happens if those do arise? If markets decline because the Fed withdraws liquidity, or even signals that it might do so, will the Fed be so quick to put it back? What happens if the Fed simply reverts to its historic role as an institution that tempers speculation rather than tacitly encouraging it? Remember how far markets fell before the Fed reacted in the last crisis. And the put/call ratio is telling us that people are focused on the upside, not the downside. It’s logical and likely correct, but it’s another display of the market’s selectively short memory.

These lessons were imparted just one year ago, and they echoed lessons that were imparted not that long ago.

Remember Santayana’s quote: “Those who cannot remember the past are condemned to repeat it.”

Also remember Sir Templeton’s quote: “The four most expensive words in the English language are, ‘This time it’s different.’”