Now that was a wild week. Coming into Friday the S&P 500 had closed down seven of the previous nine trading sessions, including drops of 1.1%, 2.1%, 3.8%, and 4.1%. This last selloff was the biggest one-day decline since 2011. We are now officially in ‘correction’ territory for the first time in two years. From the high the S&P was down -11.8% at Friday’s low before the markets bounced, while the EAFE and emerging equities were down -11.1% and -13.5% respectively high-to-low.
Despite all the worry about inflation and rising rates, bond yields actually closed lower on the week. The yield on the 10-year ended at 2.83% on Friday, down 2bps. 30-year bond yields were the only ones that moved higher – from 3.09% to 3.16%. This meant that long-term bond funds lost -1.4% for the week, roughly the same as the losses in high-yield. These relatively modest losses in credit compared to government bonds are noteworthy, and we discuss in more detail below.
What’s Behind the Correction?
What lies behind market movements? While it seems like a simple question, market drivers can at times be more about psychology than statistics. But given that caveat, let’s take a stab at outlining some of the reasons that might lie behind this latest selloff.
Markets Were Stretched
This is an easy one. The S&P had rallied more than 40% since February 2016 without so much as a 5% decline. This was the longest streak in history, as you can see below. So, while it may sound trite, we were due.
The drumbeat of inflation worries has been building for a few weeks, and this theme was given new impetus by last week’s payroll report. We found out that wages were growing at the fastest pace since 2009, and this suggested to some that supply-side constraints are beginning to bite. This, in turn, means that the runway for low inflation and easy monetary policy may not be as long as some had hoped.
Friday’s labor report was underscored by this week’s jobless claims numbers. Claims dipped to just 221K, the lowest since 1973.
Government Spending Trends
This week Congress agreed to a sweeping budget deal that would add meaningfully to federal spending over the next two years. Key points include:
1) The deal would increase government spending by nearly $300 billion over two years.
2) Discretionary defense spending would be increased by $165 billion over the spending caps that have been in place since the 2011 Obama-era budget ceiling battle left us with sequestration.
3) Non-defense spending would be increased by $131 billion. This would include $20 billion for infrastructure spending and $6 billion to combat opioid abuse and other mental health problems.
4) The government’s debt ceiling would be extended to March 2019. This is important to avoid a replay of 2011 when U.S. bonds were downgraded and fears percolated about default. The Treasury Department had warned that without an extension in borrowing authority by Congress, the government would run out of its “emergency measures” early next month.
Taking the tax cuts and budget together we are looking at materially higher deficits in 2018 and 2019, as you can see below. Some worry this will translate into more inflationary pressure than originally thought.
Rising Bond Yields
The last two items are translating into rising bond yields, as you can see below.
Higher bond yields are a challenge to the markets in a couple of ways. First, by raising the cost of borrowing for companies and consumers, they may slow economic growth. Second, rising yields typically mean lower price-earnings multiples for stocks, all things being equal.
But as we pointed out last week, we shouldn’t get carried away on the inflation theme. The chart below from Alpine shows the likely path of inflation. Price pressures typically follow growth, and this chart overlays inflation on a measure of manufacturing. Yes, inflation is likely to increase in the months to come, but we are talking about core inflation moving towards 2%, levels we saw in both 2012 and 2016, not a huge number.
Finding New Ways to Lose Money
Another key factor that has driven the losses of the last few days is the unwinding of a very popular trade in an obscure part of the market.
By way of background, in 1993 the Chicago Board Options Exchanged launched the CBOE Market Volatility Index, or VIX. This index measures the market’s expectations of 30-day volatility using numbers implied by options pricing models. Basically, if you thought volatility was going to increase you could buy the VIX. Conversely, if you thought volatility was going to fall, you could short the index. Thus, volatility became an investible asset, and over the years products have proliferated to allow people to either ‘buy or sell vol’.
Normally volatility is well behaved, but every so often prices either spike or crash. Look at the chart below. In 2015 there was a massive spike when the equity market corrected. Since then volatility has been in a pronounced downtrend.
This downtrend has led to a boom in funds that bet against volatility. As The Economist notes:
“So other (strategies) were developed to “short”—ie, bet against—the Vix index. Until this week, they were doing handsomely. Amid a long spell of subdued volatility, investors piled in. In January, assets in short-Vix funds hit a record of $3.7bn. Credit Suisse issued the largest, cutely known as XIV (reverse-Vix), which alone held over $1.9bn. Banks and hedge funds were the largest holders, but retail investors may have bought some, too.”
However, on Monday these bets came to an ignominious end. Prior to Monday the two largest short-Vix funds managed over $3 billion. Most if not all of this money has been wiped out. The chart below shows one of the two largest exchanged traded products that shorts volatility. This is one of the most spectacular blow-ups in a long time.
On Thursday we found out that an open-ended mutual fund with roughly $900MM under management basically went bust. LJM Preservation and Growth fund managed to lose most of their investor money by selling deep out of the money call and put options to capture the premium. As the FT notes:
“A fast-growing mutual fund has told investors that it will not charge them to redeem what is left of their money, after losing more than 80 per cent of its value in the wake of this week’s turbulence. The collapse in value of the options trading fund, called the LJM Preservation and Growth Fund, is the biggest one-week drop for a mutual fund recorded in 20 years by the research group Morningstar….LJM is in a class of mutual fund pitched as bringing hedge fund-like strategies to a broader swath of investors. It used options to bet on markets remaining calm and told investors that the strategy offered an alternative to traditional stock and bond investing.”
How much is left to come? No one is too sure on this point. There are probably other shoes to drop, but the key point is that none of this is creating a systemic risk. When housing crashed in 2008 it took the banking sector with it. This crippled the economy as it cut off the source of credit for many companies and most consumers. Losses in inverse volatility trades are painful for those investors who own the securities such as hedge funds and traders, but it is tough to see it as having broader implications than that. This is more like Long Term Capital Management in 1998 than Lehman Brothers in 2008. But over the short-term it can create dramatic artificial price swings.
Corrections Are Actually Normal
Finally, we should put the selling of the last few days in broader context. As Bloomberg notes:
“..(the way investors are reacting to events today), like much else when it comes to the market, is about perception and memory, which is famously short during bull markets but long during bear ones. In fact, this is the fifth correction since 2009, according to Yardeni Research, and as of right now the latest one is the smallest. The S&P 500 Index dropped 19.4 percent in 2011 before recovering. The index was down 16 percent during a stretch the year before that, during the European debt crisis.”
The chart below shows the last few corrections.
And more specifically, here is every meaningful sell-off since the financial crisis.
Each one of these was scary at the time. Headlines made a big deal of things like Europe, Greece bankruptcy, or the debt ceiling fiasco at the time. But while each seemed like a big deal, markets eventually moved forward because underlying growth persisted. In a sense the correction highlights the natural ebb and flow between greed and fear.
The one unique feature of this latest correction, though, is its speed. This is the first time in history that the S&P 500 has gone from a new all-time high to a 10% correction in 9 days or less.
Is This Noise or a Sign of Something More Ominous?
So, does this correction signal that something is rotten at the core or is this just the normal greed/fear cycle?
We lean towards the latter view for a few reasons:
• Underlying growth fundamentals are improving, not deteriorating. As we noted last week, recessions and bear markets are typically proceeded by a deteriorating employment picture. This is not the case today.
• The yield curve actually steepened this week. There has never been a serious bear market in stocks when the Treasury yield curve has been positive and steepening.
• As we noted earlier, while inflation is almost certain to increase, the magnitude of the rise this year is likely to be muted. This means rising rates should remain reflective of a solid economy. They shouldn’t move into restrictive territory this year.
• Commodity prices have been relatively resilient. This indicates reasonably low recession risks.
• In general, the early warning signs of recession are not there. The table below shows a summary of early warning signals put together by Credit Suisse. None are flashing yellow yet.
• Corporate earnings growth in the U.S. continues to be strong, with upward earnings revisions at record highs (see chart below). This isn’t something you see going into a deep bear market.
• Credit spreads have been well behaved.
Does this mean that stocks bottom soon? There is really no way of knowing. Maybe we’ve seen the worst, maybe the selling rolls on longer as investors digest the implications of higher rates.
At the moment we are certainly stuck in a battle between inflation and interest rates on the one hand and decent (even improving) growth and earnings fundamentals on the other. What it means is that volatility is likely to stay high. As BCA noted this week:
“Monday’s sell-off marked an inflection point in the low-volatility world that has prevailed over the past few years. The VIX Humpty-Dumpty has been irrevocably broken. Going forward, volatility will remain elevated relative to what investors have come to expect. As the experience of the 1990s shows, stocks can still go up when volatility is trending higher, but this is going to make for a much more challenging investment environment.”
For those who find the volatility unnerving – the classic ‘can’t sleep at night’ indicator – a conversation with your financial advisor is well advised. But for long-term investors this is probably another in a long series of bumps that are best ignored, or even taken advantage of.
Have a good weekend.
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