I have almost forgotten the taste of fears.
The time has been my senses would have cooled to hear a night-shriek,
and my fell of hair would at a dismal treatise rouse and stir as if life were in it.
Volatility is back
These are the real-world fundamentals we have right now: solid economic growth, improving wage growth, excellent corporate profitability and earnings, stable job growth into already minimal unemployment, continued deregulation, high sentiment, and a likely windfall for to GDP in 2018 due to the recent tax cut stimulus. Surely, there are some negative consequences to these circumstances but, taken in totality, most economists and pundits would say we have had a robust economy and great market environment for the past few years.
2017’s market was notable for its headlong climb upwards without any pullback at all. It was all greed and no fear. This ended in late January and early February of 2018. Pullbacks are normal and, frankly, we were due for one. However, the acceleration of the correction caught some investors off-guard.
The past few weeks reminded markets what volatility – good old-fashioned fear – looks like. Monday, February 5th was the best example. The downward move in equities had already started and Monday looked to continue the trend, with the Dow Jones Industrial Average down about 500 points through most of the day. Around 2 p.m. several technical floors were breached, automatic selling orders were triggered, volume spiked, and the markets lurched – at one point down 1600 points before settling at a record breaking 1200 point daily loss.
The short term volatility spike
Why did this happen? We know enough about trading behavior and outstanding orders to model the reasons for the short term volatility spike. One contributing factor to the heightened panic of February 5th was automated trading. Black box trades or algorithmic trading programs certainly were responsible for the flash-crash & recovery swings during the final few hours of trading on February 5th. More specifically, a combination of technically driven momentum strategies and circuit-breaker loss-minimization strategies flooded the exchanges with orders at the same time. While the exchange struggled to match orders, it took a while to find a proper floor.
Also regarding the intensity of February 5th, entertainer and commentator Jim Cramer was quick to point the finger at abuse of four specific ETF instruments - UVXY, VXX, TVIX, and SVXY. These high-volume, often-leveraged instruments trade on the volatility index itself - the VIX. Cramer argues these funds were used by speculators and hedge fund managers to short the volatility index and they got caught on the wrong side of a failing trade, so panicked selling was necessarily to cover their decimated short positions.
Volatility and the pullback
Investigations to specific trading patterns doesn’t do much to explain the overall cause – the spark to the flame – which has sent markets lower over the past few weeks. If we knew why this happened, we might be able to predict when this will happen again or if the market has stabilized for the time being. Sadly, there are competing (sometimes contradictory) theories, so a definite answer may be elusive.
As a forewarning, let us first consider what is not accepted as a cause for the pullback. Virtually nobody has suggested this pullback is a harbinger of an imminent recession. For whatever reason the pullback occurred, most categorize the drop, no matter how alarming, as “overdue” and even “healthy”. With this caveat out of the way, let’s consider some of the potential causes for the pullback being bandied about.
1. Valuations are too high
We’ve had nine years of equity gains, and lately those gains have come easily. Since February 2016, we’ve run without a mere 5% correction. 2017 was a stellar year for investors and January 2018 also wound up nicely. Most of these gains are based on healthy earnings, which aren’t under any definite threat. As Fidelity notes, “last week's correction ironically happened despite a dramatic rise in earnings estimates, with the consensus estimate for 2018 earnings growth now at +20%.” Still, an untested market is conducive to an overbought market, prone to sharp corrections.
2. Did retail investors sell-off?
Consider, even with the recent pullback, the markets are in line with Q4 2017 levels. Retail investors who receive investment news quarterly may scarcely recognize the change since, at the time of this writing (Valentine’s Day) average balances should be quite close to January 1st, 2018 levels. In other words, this “pullback” will seem immaterial to investors looking at periodic statement balances.
On the other hand, there is evidence of herding behavior and increased trade volume, almost three times the daily average, during the pullback. AGF Investments reports the recent selling was primarily from retail day-traders while institutional market participants were largely buyers. Furthermore, traffic congestion at retail-oriented trading platforms during the worst of the pullback bolsters the case for unsophisticated investors selling into the panic.
3. Or was it scheduled institutional rotations?
Portfolio rebalancing – getting back to a strategic target allocation of equity and fixed income – is conducted by individuals and institutions alike. However, institutions tend to conduct these exercises on a predictable, and unintentionally coordinated, schedule. Large institutional broker / dealers - Morgan Stanley, Goldman Sachs & Credit Suisse - noted a large amount of pension rebalancing. This could have been the catalyst of the selling pressure on the equity markets at the end of January.
4. Excessive borrowing
New budgets and updated revenue forecasts have been rolling out to reflect the recently enacted tax cut bill. The annual federal deficit is forecasted to jump upward from $400 billion a year to a record shattering $1 trillion per year. That requires a lot of new bond issuance, at a time when central banks worldwide are ending bond-buying quantitative-easing programs. In other words, there is a lot of upcoming bond-supply into a potentially oversaturated market. Thus, treasury yields have been moving upward to entice lenders given the increased debt load.
5. Inflation worries
Just today, a small (0.1%) increase in the Consumer Price Index spooked pre-market trading into negative territory. A surging economy operating at capacity creates bottlenecks and scarcity, which in turn inflates prices. Against a backdrop of moderate US GDP growth (+2.6%), increased IMF global growth targets (3.9%), a tight labor market (4% unemployment) exhibiting wage-growth in excess of estimates (2.9% vs. 2.6% in December), and higher minimum wages in key markets, inflation concerns are inevitable. Inflation is a bit of a double-edged sword to equities; whereas equities and real assets historically retain their relative value better than bonds and cash in periods of high inflation, the underlying model valuations of equities still suffer as inflation rates increase.
6. Rising interest rates
This mélange of high borrowing, high global growth, and high inflation environment each encourage monetary policy makers to increase borrowing rates, which in turn pushes bond-yields higher and bond-prices lower. To wit, by the end of January, the 10-year Treasury yields were hitting four year highs (about 2.8%, a 40 basis point bounce year-to-date) and all investment grade sectors in bonds had negative returns. Complacent investors, lulled by steady gains in both bonds and equities, were shaken. Expressed more formally by Brian Barish of Cambiar, “what we are seeing is that directional volatility in one asset class (bonds, starting in January) which has been consistently inversely correlated with stocks suddenly becomes very correlated with stocks as risk abatement in one asset class statistically forces risk abatement in others.”
Again, higher interest rates lower future earnings in net-present-value calculations. Thus, the market’s expectation of ever increasing earnings and profits have to be newly tempered by the increased likelihood the Federal Reserve will increase borrowing rates three times (perhaps four times) in 2018.
Westminster Consulting focuses on long-term strategic investing, based on a client’s risk-tolerance and long term goals This means we will generally not change our investment approach due to these inevitable market corrections. Please contact us if you have any questions.