Posts tagged Stock Market Volatility
Spring has come early to the US East Coast this year, with the good citizens of Atlantic seaboard cities ditching their North Faces and donning shorts and flip-flops for outdoor activities normally kept on ice until April. Grilling, anyone? Equity investors, meanwhile, have been enjoying an even longer springtime, full of balmy breezes of hope and animal spirits. But just as a February spring can fall prey to a sudden blast of March coldness, this week has brought a few hints of discontent to the placid realm of the capital markets. Whether these are harbingers of choppy times ahead or simply random head fakes remains to be seen, but we think they are worthy of mention.
Ach, Meine Schatzie!
Fun fact: German two year Bunds go by the nickname Schatz, which is also the German word for “treasure” as well as being a cozy term of endearment for loved ones. Well, these little Teutonic treasures have been exhibiting some odd behavior in the past several days. This includes record low yields, a post-euro record negative spread against the two year US Treasury, and a sudden spike in the gap between French and German benchmark yields. The chart below shows the divergent trends for these three benchmarks in the past couple weeks.
The sudden widening of the German and French yields offers up an easy explanation: a poll released earlier in the week showed National Front candidate (and would-be Eurozone sortienne) Marine Le Pen with a lead over presumed front runner Emmanuel Macron. That was Tuesday’s news; by Wednesday François Bayrou, another independent candidate, had withdrawn and thrown his support to Macron, easing Frexit fears. Yields fell back. Got that?
The Schatz yield also kept falling, though, as the dust settled on the latest French kerfuffle. Since German government debt is one of the more popular go-to markets for risk-off trades, we need to keep an eye on those historically low yields. This would be a good time to note that other European asset classes haven’t shown much fretting. The euro sits around $1.06, off its late-December lows, and equity markets have been fairly placid of late (though major European bourses are trading sharply lower today). But currency option markets suggest a growing number of investors positioning for a sharp reversal in the euro come May.
Gold Bugs and Trump Traders Unite
Bunds are not the only risk-off haven currently in favor; a somewhat odd tango has been going on for most of this year between typically risk-averse gold bugs and the caution-to-the-wind types populating the Trump trade. The chart below shows how closely these two asset classes have correlated since the end of last year.
Now, an astute reader is likely to point out that – sure, if the Trump trade is about reflation and gold is the classic anti-inflation hedge, then why would you not expect them to trend in the same direction? Good question! Which we would answer thus: whatever substantial belief there ever was in the whole idea of a massive dose of infrastructure spending with new money, pushing up inflation, is probably captured in the phase of the rally that started immediately after the election and topped out in December. During that phase, as the chart shows, the price of gold plummeted. That would be odd if gold investors were reacting to (higher) inflationary expectations.
Much more likely is the notion that gold’s post-November pullback was simply the other side of the animal spirits; investors dumped risk-off assets in bulk while loading up on stocks, industrial metals and the like. In that light, we would see the precious metal’s gains in early 2017 more as a signal that, even as Johnny-come-lately investors continue piling into stocks to grab whatever is left of the rally, some of the earlier money is starting to hedge its gains with a sprinkling of risk-off moves, including gold.
None of this should be interpreted as any kind of hard and fast evidence that the risk asset reversal looms large in the immediate future. Market timing, as we never hesitate to point out, is a fool’s errand that only ever looks “obvious” in hindsight. An article in the Financial Times noted today that the recent succession of 10 straight “up” days in the Dow Jones Industrial Average was a feat last achieved in 1987, with the author taking pains to point to the whopping market crash that happened the same year. He waited until the end of the article to deliver the punch line: anyone who took that 10 day streak as a sign to get out at the “top” of the market forfeited the 30 percent of additional gains the Dow made after that before its 20 percent crash in October (do the math). Ours is not a call to action; rather, it is an observation that dormant risk factors may be percolating up ahead of choppier times.
Over the past couple weeks we have been snooping around some of the contrarian corners of the world, to see what those folks not completely enamored of the “Trump trade” have been up to (Eurozone, Brexit, what have you). While we were away, all manner of things has gone down in Washington, often in a most colorful (or concerning, take your pick) fashion. But virtually all the chief planks of that Trump trade – the infrastructure, the corporate tax reform – remain stuck in the sketchbooks and doodlings of Paul Ryan and his band of policymakers, waiting to see the light of day. By this point in his first term, Barack Obama had already passed a $1 trillion stimulus bill, among other legislative accomplishments. Is there a point at which the band of inverse-Murphy’s Law acolytes begin to question their faith that if something can go right, it will? To put it another way, does political risk still matter for asset valuation?
“Vol Val” Alive and Well
If there is a political risk factor stalking the market, it appears to have paid a call on J.K. Rowling and come away with a Hogwarts-style cloak of invisibility. For evidence, we turn to our favorite snapshot of trepidation and animal spirits – those undulating valleys of low volatility occasionally punctuated by brief soaring peaks of fear that make up the CBOE VIX “fear gauge,” shown in relation to the price performance of the S&P 500.
Since the election last November, market volatility as measured by the VIX has subsided to its lowest level since the incredibly somnambulant dog days of summer in 2014. In fact, as the chart shows, the lowest vol readings have actually occurred on and after Inauguration Day (so much for that “sell the Inauguration” meme making the rounds among CNBC chatterboxes a few weeks back). Meanwhile, of course, the S&P 500 has set record high after record high. How many? Sixteen and counting, to date, since November 9, or about one new record for every four days of trading on average.
That by itself is not unheard of though: the index set a new record 25 times (measured over the same time period) following Bill Clinton’s reelection in 1996. But 1996 was a different age, one with arguably less of the “this is unprecedented” type of political headlines to which we have fast become accustomed in the past two months. To a reader of the daily doings of Washington, it would seem that political risk should be clear and present. One of this week’s stories that caught our attention was the good times being had by London bookmakers setting betting markets for the odds of Trump failing to complete his first term (the odds apparently now sit around 2:1). So what gives with this week’s string of record highs and submerged volatility?
The Ryan Run-up
The “Trump bump”, of course, was never about the personality of the 45th president, or anything else that he brings to the table other than a way to facilitate the longstanding economic policy dreams of the Ayn Randian right, represented more fulsomely by House Speaker Paul Ryan than by Donald Trump. Looking at the rally from this standpoint perhaps explains at least in part the absence of visible political risk. So what, goes this line of thinking, if Trump were either to be impeached or somehow removed under the provisions of the 25th Amendment? Vice President Pence ascends to the Oval Office, the Twitter tornadoes subside and America gets on with the business of tax cuts and deregulation in a more orderly fashion (though not much infrastructure spending, as that was never really a Ryan thing). Move along, nothing to see here.
While we understand the logic behind that thinking, we think it is misguided, not least of all because – London oddsmakers notwithstanding – we think that either impeachment or a 25th Amendment removal from office are far out on the tail of any putative distribution of outcomes. We would ascribe a higher likelihood to a different outcome; namely, that political uncertainty will continue to permeate every sphere of activity from foreign policy to global trade to domestic unrest in a bitterly divided, partisan nation. So far we are muddling through – headlines aside, many American institutions are showing their resilience in the face of challenge. That’s good news. But not good enough, in our view, to keep political risk behind its Invisibility Cloak for much longer. We’re not prophesying any kind of imminent market cataclysm, but we do expect to see our old friend volatility make an appearance one of these days in the not too distant future.
It’s enough to make one sort of miss those crazy Octobers when goblins and other malevolent spirits wreak havoc on asset markets. Remember 2014? A weird flash crash in U.S. Treasury yields spooked investors already jittery about the Ebola virus making sensational front page headlines. The S&P 500 fell to just short of a technical correction in intraday trading before rebounding sharply as it became clear that there was no “there” there. A vigorous Santa rally carried the U.S. bellwether index up to a then-all time high right before the end of the year.
Mario Wins the Toss, Elects to Defer
At least that gave us something to write about. October 2016 thus far is a fine month for those who value calm and serenity, but for market scribes it is notably bereft of attention-grabbing headline events. Share trading volume this month on the New York Stock Exchange is somewhat below its average daily levels back in August. August, for heaven’s sake! It would appear that stock markets are catching the soporific vibes of the central banks they so assiduously follow, most recently the European Central Bank. On Thursday, ECB Chairman Mario Draghi summed up deliberations of the body’s governing council thus: We’ll talk again in six weeks. Ciao!
The ECB has a raft of unsolved problems, but this week was apparently not the time to provide any guidance as to their progress. Markets widely expect the bank will extend the current program of monthly €80 billion purchases beyond the current termination date of March 2017. However, the ECB’s rules on asset eligibility are at odds with the actual supply of viable paper in the market. Those rules probably will have to change in order to facilitate a meaningful extension of the program. Such change in turn will require agreement from the council’s German and other northern European hawks. Draghi’s deference to the December meeting likely stems from a lack of consensus today as to how to remedy asset eligibility rules to facilitate an extension of QE beyond March.
Earnings: Low Bar Well Cleared
Meanwhile, the third quarter earnings season is, rather predictably, serving up a nice dollop of upside surprises. With a bit more than 20 percent of S&P 500 companies reporting to date, both top-line revenues and mid-bottom line profits are mostly outperforming analysts’ expectations heading into the season. We expect that, when all is said and done, the average EPS growth number will be slightly positive as compared to the minus 2.6 percent consensus number projected a couple weeks back.
Yet, while upbeat earnings reports have helped a handful of individual names thus far, those low share volume figures and lackluster price drift for the S&P 500 overall indicate that, for the moment anyway, earnings season is not serving as much of a catalyst for a broad-based rally. Shares remain expensive by traditional valuation metrics, as we have frequently pointed out in these pages. Investors still have a more skeptical take on companies’ forward guidance projections, and headwinds including the dollar and weak foreign demand haven’t gone away. Until guidance announcements provide more evidence of a near-term future of double-digit EPS growth, a couple of quarters clearing a very low bar probably won’t do much to shake off the lethargy.
When Nothing Becomes Something
We still have six weeks to go before that next ECB conference, and even longer to wait for the white smoke to appear from the Eccles Building in Washington D.C. signifying the Fed’s next move. Six weeks is a long time for “nothing” – as reflected by sideways prices, low volatility and vanishingly thin trading – to continue. Some technical indicators including shorter term moving averages and 52-week highs vs. lows suggest some top-heaviness. While we don’t see any obvious lurking threats that could move from potential to kinetic (yes, including the U.S. election which, as we have pointed out before, is largely baked into current price levels), the current quiet does strike us as too quiet.
Often it is not one thing, but rather a random confluence of several things, which gives rise to sharp price reversals. The example we provided above of the October ’14 correction illustrates this well: a sudden data point anomaly (the Treasury yield flash crash), amidst a raft of vaguely disquieting, uncorrelated event headlines and a new wave of commodity price drawdowns, converged to trigger sell signals from trading program algorithms. More often than not, these turn out to be short-lived tempests. It’s been awhile since we had one, though.
A deadly terrorist attack in Nice last Thursday was followed by a failed coup over the weekend in Turkey. China’s contentious “Nine-Dash Line” in the South China Sea is on a potential collision course with the U.S. military. A dismal post-Brexit PMI reading in Britain offers the first piece of data suggesting a possible autumn recession. Establishment institutions around the world reel from public distrust, and in politics it seems conventional rules no longer apply.
Yet stock markets appear blissfully dismissive of the planet’s woes. The S&P 500 has resumed its record-setting ways after a hiatus of more than one year. Meanwhile the CBOE VIX, the so-called “fear gauge” of market sentiment, fell to a two year low earlier this week, a stunning 54 percent plunge from the June 24 high in the immediate aftermath of Brexit. Do these signals – a placid VIX and a stock market upside breakout – signal the beginning of another extended run for the seven year old bull? Or are we in a brief calm before the next storm?
The VIX is subject to abrupt and dramatic mood shifts, as the above chart clearly shows. Those Alpine spikes tend to occur when something unexpected shocks investors out of complacency. Three notable examples in this chart, which goes back two years, were the Ebola freak-out in October 2014, the Chinese yuan devaluation in August 2015 and of course the Brexit shock last month. The Ebola and Brexit events appear similar in their brevity – less than a week of fear – and in the fact that in both cases stocks went right back to setting record highs. In both cases the market’s snap judgment appeared to be “nothing here, carry on”.
By contrast, risk and uncertainty lingered longer after the yuan devaluation last August, with the VIX staying at an elevated level for about five months until peaking again this past February. This is perhaps not surprising. The importance of China to the world economy makes it harder for investors to simply shrug off a negative surprise like the devaluation. Questions about China’s growth sustainability, debt overhang and impact on world commodity markets remain, even if they have mostly been out of the headlines of late.
A Tale of Two PMIs
Is Brexit really just an Ebola-like flash in the pan, an event unlikely to have much impact outside Great Britain’s borders? Since the vote one month ago (a month already, really?) there has been plenty of opinionating about what it all means, but not much in the way of data. Today we finally got a little quantitative morsel on which to chew. The July monthly purchasing managers surveys (PMI) came out for both Britain and the Eurozone, and they painted a distinctly diverging picture. In the Eurozone, both the manufacturing and the services PMI came in right about where they were a month ago, at 51.9 and 52.7 respectively. A PMI greater than 50 signifies an expansion while a number below 50 indicates a contraction.
In the UK, by contrast, the manufacturing PMI fell from 52.1 last month to 49.1 in July, while the services PMI fell from 52.3 to 47.4. Analysts have been quick to point out that the data are consistent with a scenario for a UK recession as early as this fall. We should note that PMI is only one measure of economic activity, so due caution is advisable before rushing to judgment. In our opinion, though, if there is anything substantive to take away from today’s PMI it is the Eurozone number. A British recession spilling over into a Eurozone recession would be cause for concern, but evidence in support of that scenario has not shown up yet. Indeed, while leaving Eurozone interest rates untouched this week, ECB Chair Mario Draghi expressed confidence in the current economic state of the union.
Not Worried, or Not Present?
Perhaps the market is right that, even with all the mayhem going on in the world, there is no compelling case to make for the bull to change course and reverse. It’s also possible that the lack of worry indicates that nobody is paying much attention. As we noted in our piece last week, we are in that time of the year when trading volume subsides and gives way to beach reads. Volume on the New York Stock Exchange has been well below average during the recent post-Brexit rally. Maybe investors are more concerned about leveling up in Pokémon than they are about world events. For now, in any event, this quiet spell appears fairly impervious to disruption.
One week from today we will (probably) know the answer to the Big Question: Are they in or are they out? Britain votes on the future of its relationship with the European Union on June 23, deciding whether it wants to continue to be part of an organization it joined in 1973. While the vote is technically a referendum, not a binding obligation with legal force, a Leave vote would likely require the government to set the wheels in motion for a proposed exit within a two-year time frame. What the terms of any actual deal would look like remains unclear, despite the impression created by much handwringing this week that the economic pain of a Brexit is precisely quantifiable.
Most of the conversations we have had with clients over the past several weeks have, understandably, homed in on the practical implications of Brexit for their portfolios. From our standpoint, the playbook ahead of June 23 is very much in line with our usual advice about event-driven market movements, which is to say do nothing. Make no mistake, if the Leave vote prevails next week there is a very good chance of an immediate volatility spike in asset markets. Much of that volatility would likely be concentrated in ground zero exposures like the FTSE 100 stock index and the British pound, which could see double digit declines, but risk asset markets worldwide would be vulnerable.
The reason we advise our clients to do nothing in situations like this is that, far more often than not, the tempest surrounding the actual event blows over rather quickly. The volatility is driven mostly by short-term money positioned one way or another before the event and algorithms wired to react immediately upon the outcome being known. That flurry of activity will settle down as the winners lock in their gains and the losers bite the bullet on pain trades to cut their losses. Markets will then adjust over time as investors assess the practical implications of Britain outside the EU for the future cash flow generation potential of the companies in which they invest.
Here is one practical example of what we mean by separating the short-term tempest from the longer term market adjustment to new information. Much has been made this week of the spike in volatility for the pound sterling, with commentators noting that the risk spike is higher than anything seen since the 2008 market crash. But an excellent article in Bloomberg carefully points out what other pieces have glossed over: the volatility spike relates only to what traders expect in the next 30 days. In other words, while 30-day futures for the pound sterling are more volatile than those for the Russian rouble or Hungarian forint, one-year sterling futures are virtually unchanged. The market for sterling futures today is a textbook definition of an event tempest: rough seas today, calmness further ahead.
None of this is to say that Britain’s leaving the EU would be unimportant, or have no implications down the line. We are of the opinion that the Leave arguments are largely misguided and shaped more by emotion and fear than by real facts. To that end, our longer-term concern is less about how Britain finds its economic footing outside the EU, and more about how Brexit is part and parcel of a larger global trend – a backlash against trade and globalization in general that seeks refuge in – depending on where in the world one happens to be – appeals to nationalism, authoritarianism and populism. Such sentiments swirl about in locations from Peoria to Paris to the Philippines.
But trying to put a specific price on anything as vague and variable as anti-globalism is a fool’s errand. In a very practical sense we are not prepared to adjust our strategic allocation targets to various asset classes on the basis of events that may or may not transpire. Sometime in the future economic historians may look back at June 2016 as an important milestone towards a new world of less trade and weaker economies. Alternatively, they may write that the populist anger of this age finally forced global elites to wake up and meaningfully address key imbalances and inequalities feeding that anger. Either way, we will follow the same approach as always: evaluate the data as they come in and let the data, not ill-defined emotions, drive our ongoing portfolio decisions.