Posts published in August 2015
Well, that happened. The technical correction we have all talked about for the past four years finally showed up and sent pretty much any asset class with a risk component into a tailspin. The magnitude of the correction (thus far) is nothing particularly out of the ordinary as these things go: the S&P 500 was down 12.4 percent from its May 21 high when the markets closed on Tuesday (it recovered about half of that in the subsequent two days). But this action-packed sequence of six negative trading days produced some curious artifacts and served notice that, while history is more likely to record this event as a bull market correction than a bear market onset, we should be prepared for more twists and turns down the road. Here are five things we observed from this week’s craziness.
#1: ETFs – The Scream Heard ‘Round the World
Call it a delayed coming-out party for an asset that came into this world some twenty two years ago. ETFs promised cheap, efficient access to the market via index proxies, and by and large they have delivered on that promise. More recently, though, ETFs have become the asset of choice for a wide range of active and quasi-active strategies, employed by a spectrum of participants from seasoned investment pros to couch potato day traders. Their presence during the more insane moments of the pullback was unmistakable.
Consider the S&P 500 – the very living, breathing embodiment of a broad market benchmark. Two ETFs widely used as proxies for the S&P 500 are SPY, the SPDR product present at the ETF creation in 1993, and IVV, the BlackRock iShares offering. SPY has a market value of over $163 billion, while IVV clocks in around $67 billion. Pretty liquid, no? But something went seriously wrong with IVV on Monday morning. From a Friday close of $198, IVV shares briefly plunged to a low of $147 shortly after the Monday open. That’s a loss of almost 26 percent - far more than the index itself. Far more, in fact, than SPY, which in the same time period lost about 7.6 percent from its Friday close, more in line with what the market itself was doing. Now, the discrepancy didn’t last long, and both ETFs finished the day closely tracking the index. But that will be small comfort to those whose IVV orders were filled at peak divergence. Small comfort, as well, to the rest of us who care about fair and orderly markets.
#2: Rear-Window Vision Is Alive and Well
Pullbacks – as opposed to actual bear markets – are like sandstorms in the desert. You know they’re going to happen, but you’re still surprised every time the sand blows up into your face. As always, it didn’t take long for pundits of various stripes to start filling pages with their “I saw this coming” narrative. Did we learn anything new about the world last Friday? Sure, Shanghai and Shenzhen took another pasting. Yes, sagging commodities prices are probably a better measure of China’s economic slowdown than the official statistics. But A shares started tanking back in June, and China’s more modest pace of activity has been an ongoing story for the last year.
So why now? It’s a variation on the butterfly wings of chaos theory – a conflux of random events around the world creates the conditions for the storm. Same as it was last October, when the Ebola scare, a mysterious drop in bond yields and falling oil prices were ascribed to that month’s 7.5 percent pullback. Now, are there investors out there on the right side of the trade when these events happen? Of course – statistically it would be nearly impossible for there not to be. But getting the timing right for these brief flare-ups is much more about luck than skill.
#3: Noise 1, Signals 0
While the size of the reversal was not out of line with past correction environments, certain metrics seemed way out of line. Front and center among those is volatility. On Monday, August 17 the CBOE VIX closed at a gentle 13, not far from where it had traded throughout a mostly calm summer. One week later it was reaching intraday levels last seen during the 2008 meltdown and closed at 41 – roughly the same as where it closed on the first post-9/11 trading session back in 2001. Very likely, the unusually high vol spike is not unrelated to our observation #1 above – the amplification of price swings provided by ETF-heavy short term trading strategies.
The so-called Copenhagen Interpretation theory of quantum mechanics posits that the act of observing an event at the subatomic level influences its outcome. Increasingly we seem to have a Copenhagen Interpretation of the capital markets: the aggregate behavior of the tens of thousands of algorithms programmed to go this way or that when triggered by a signal wind up altering the signal – arguably making that signal less useful as a predictive metric going forward. Traders using traditional volatility signals would probably be well-served to revisit their algorithms once the dust from this flare-up has settled.
#4: It’s 1998 Again!
Not really, of course. But there are some interesting parallels. In the middle of 1998 we were well into a bull market, valuations were stretched (to say the least) and various unsettling things were going on in the world. All of which was enough to send the S&P 500 into a 19 percent reversal from its July high to early October. As usual, it was easy for commentators to conjure up world-is-ending talking points: Russia defaults! LTCM goes bust! Clinton impeachment! We were both there – the times were indeed unsettling. But investors who bailed out in a September panic missed out on another year and a half of a stampeding bull. Again – we do not mean to be facetious and suggest that history will repeat itself. Sooner or later the bear will likely emerge from its lair. But we think it more likely that the bear will reveal its hand with a few more corrections – with at least one giddy “melt-up” along the way – before we write the coda on this bull.
#5: The Song Remains the Same
Every so often we go back to the Annual Outlook we published back in January to see where our views have changed and where they haven’t changed. It is noteworthy as to how much of this year’s story remains the same. Continued modest but steady growth in the US? Check – amid this week’s mayhem we had strong readings on consumer confidence, durable goods and the 2Q GDP revision. Europe managing to stay a few feet away from the deflation abyss? Check. Emerging markets struggling to regain their long-lost tag of “growth engine” while China struggles to maintain momentum? These are the fundamentals as we see them. They are in our opinion not inconsistent with the type of correction we saw this week, but also not the likely ingredients for a global recession that would drag down global asset markets for a long spell.
We expect to see more volatility ahead, with an eventful September just around the corner and the tricks and treats of October lurking beyond. For the time being, though, we think these are conditions to play through, and not panic over.
Dog days indeed. August has taken one of its characteristic twists for the worse, with a global pullback in risk assets finally encroaching on US large cap equities. On the heels of increasing instability in China, collapsing commodity markets and little to cheer about elsewhere, the S&P 500 had retreated 4.5 percent from its May high by Thursday’s closing bell. In early Friday trading the bellwether index has crashed further still to send the peak-to-trough meter past the 5 percent mark. Plenty of market pundits will be on the airwaves today reminding us of how many hundreds of days it has been since we experienced a “real” correction of 10 percent or more (another “dog days” event, in August 2011).
As investors we need to take these pullbacks seriously – but we also have to keep them in perspective. Since 1950 the S&P 500 has experienced 177 instances of a peak-to-trough reversal of 5 percent or more (where the reversal was followed by a recovery of 5 percent or more). In that time there have only been four full-on bear markets: two bookending the sluggish 1970s and then the two signal events of the 2000s: the dot-com rash and the Great Recession. The market did retreat by more than 20% in the Black Monday crash of 1987, but that turned out to be short-lived and quickly recovered. For the moment, anyway, we are inclined to see the current climate as one of those 5 percent-plus events (if indeed the market remains negative through the close) that doesn’t metastasize into something more unpleasant.
Reading the Vol
Volatility is not a perfect measure, but it is a useful tool for gauging how bad things are. The chart below plots the trend of the CBOE VIX index against the S&P 500 over the last two years.
Volatility has been fairly subdued for most of the year. Investors tend to regard a VIX level of 20 or more as indicative of significant market risk. We briefly touched that mark at the height of “Grexit” fears last month, but even that event failed to sustain volatility above its baseline level. Last October’s sharp equity reversal, with a strange flash crash in Treasury yields and a 7.5% pullback for the S&P 500, sent volatility up to levels not seen since 2011. That too, though, turned out to be a short-lived event that caught a great many quantitative hedge strategies flat-footed. Again, the message here is that volatility has crept back into US large caps, but so far there is little to suggest the onset of deeper problems.
Stressed in Shanghai
Meanwhile, asset markets on the other side of the Pacific are deep in bear territory. China’s monetary mandarins appear to be losing their grip on the domestic stock markets in Shanghai and Shenzhen, both of which have tumbled close to 10% or so in the past couple days. Manufacturing data for the first three weeks of August are at the lowest levels since the financial crisis, adding to the perception that China’s economy is in worse shape than the most recent GDP numbers indicate. As goes China, so go emerging markets. The Malaysian ringgit and Indonesian rupiah are testing the lows against the dollar reached during the 1997 currency crisis, and the Turkish lira is plumbing all-time depths. These developments only add to the general malaise that has settled over the asset class formerly known as the growth engine of the global economy.
Money Has to Go Somewhere
Our position, articulated a handful of times in recent commentaries, is that there are greater risks outside the US than within, and that equity portfolios should be aligned accordingly. We continue to be of that view. The market may be giving us a bunch of bitter lemons, but we still have to make lemonade. The problems in Asia Pacific and the Eurozone are unlikely to go away any time soon, and commodities have the characteristics of secular rather than cyclical weakness. In this environment, high quality large cap US equities continue to make a compelling case as the best of a bad lot. Indeed, the current selloff is likely to present some attractive entry points for good companies whose rich pricing has kept value investors at bay.
The key thing, however, is to go back and review the math of pullbacks: they happen with some degree of frequency, but usually do not collapse into all-out bear markets. Patience and discipline are always the best way to prevent paper losses from becoming actual losses.
Ah, yes, it is turning out to be another one of those unpredictable Augusts. US East Coasters woke up Tuesday morning to news of a major devaluation of the Chinese currency, the renminbi (RMB). Global asset markets then spent several days lurching this way and that as investors attempted to divine the meaning behind the sharply lower RMB reference rate set by the People’s Bank of China (PBOC), the nation’s central bank. As another summer weekend approaches, the preliminary consensus appears to be of the “tempest in a teapot” variety. Most bellwether asset classes have stabilized over the past forty eight hours. But investors heading back out to their boats and beach houses will likely still be pondering the Chinese currency’s near term prospects, and how this new twist adds to the brew of ingredients shaping possible Fed moves in September.
Market Adjustment or Currency War?
It is important to understand what did – and did not – happen this week. Every morning the Chinese monetary authorities set a reference rate for the RMB, and market makers are allowed to trade within a two percent range around that reference rate. Prior to Tuesday, the daily published reference rate had no explicit relationship whatsoever to market forces. There was no formula linking the reference rate to the previous intraday close or to perceived market supply and demand; rather, the reference rate was simply what the PBOC thought it should be.
Tuesday’s reference rate set the RMB at a level 1.9 percent below the previous close, and that announcement unleashed a flurry of pent-up selling pressure to take the currency down the daily maximum two percent from the morning rate. By the end of the week the net effect of the PBOC’s moves and market trading was a 4.4 percent decline in the value of the RMB versus the dollar. That was a move of a sufficient magnitude to push the topic of currency wars back into the discourse. However, the evidence so far does not support a clear-cut conclusion that China’s actions are motivated primarily by goosing up its export competitiveness.
Admission to the Club
Chinese policymakers this week pointed to the goal of a more tangible link between market forces and the RMB as driving the recent reference rate policy decisions. There is some convincing logic behind these statements. It is no secret that China would like to see enhanced reserve status for the RMB and a more prominent role for the currency in global trade and finance. An important milestone for this goal would be to have the RMB admitted to the elite club of IMF Special Drawing Rights (SDR) currencies, taking a seat alongside the dollar, euro, yen and pound sterling. Engendering more market transparency for the RMB is seen by many as a necessary box to check off for admission to the SDR club. Of course, proof that this is in fact China’s primary goal will require the People’s Bank of China to allow the currency to strengthen (thus weakening exports) as well as devalue when market forces so dictate.
Back to the Fed
Whatever the reason, a weaker renminbi is likely to factor into the calculus of the Fed’s forthcoming decision on whether to kick off its rate program in September. A rate hike that resulted in a sharply higher dollar, in the context of an already lower RMB, could have unfavorable economic consequences for US growth and prices. Such a scenario could give the Fed pause and push its decision back to December. The data would suggest this is likely, with recent headline GDP, employment and inflation numbers decent but certainly not indicative of an overheating economy. Alternatively, the Fed may simply want to get on with it and end the continual will-they-won’t-they chatter. If it does come in September, though, the rate hike may possibly be the most dovish ever.
“Every unhappy family is unhappy in its own way.” The opening sentiment in Tolstoy’s great novel Anna Karenina works just as well for commodities markets in the summer of 2015 as it did for Russian aristocratic clans in the 19th century. Every major commodities “family” – from precious metals to energy and industrial metals – is unhappy. And the reasons are quite specific to each. Oil suffers from a supply glut. Copper and nickel feel the brunt of contracting production in China. Gold has lost its luster as a safe haven – nobody went piling into gold during the recent turmoil in Greece, for example.
Oh, sure, there are exceptions to the rule out there in the byways and back roads of the commodities world. Traders put a “squeeze” on robusta coffee futures last month and bid September contracts up to a ridiculous spread versus July delivery. But by and large, it has been a long and hard summer for the global economy’s major physical inputs. The chart below illustrates the shared pain.
As dismal a picture as this chart paints, it does not even tell the full story. From its last six years’ high point in April 2011, Brent crude oil has tumbled 61 percent. Copper has fallen by nearly 50 percent over the same period, and gold’s retreat has topped 40 percent. Imagine what the conversation would be if major equity indexes had spent the past six years falling on an order of this magnitude. When the S&P 500 gives ground in the high double digits, retirement nest eggs look fragile and the prospect of recession looms large. When oil prices plummet – well, we just pay less at the pump. Good news, right? Not necessarily. Commodities price trends give us important information about the world economy. Right now the news is decidedly mixed.
Awash in Supply
Oil bulls got sideswiped by a steady drip-drip of supply news in July, with accelerating OPEC production dominating the headlines. Saudi Arabia remained firm to its commitment articulated last November to gain share rather than support prices through restricted output. Production in Iraq reached record levels. And the prospect of Iran – holder of the world’s fourth-largest proven reserves – reentering the market after years of sanctions added a further depressive element. Meanwhile, US shale producers still appear mostly determined to power through the downturn and find ways to further reduce their cost structures rather than let up on output.
The China Malaise
The unhappy story told by industrial metals is set in China, which is by far the world’s largest importer of copper, aluminum, nickel and other key metals. Forget about all the eye-popping gyrations on the Shanghai and Shenzhen stock bourses. The really important story in China is the slowdown in growth, punctuated by a sharper than expected manufacturing contraction in both June and July and coming on the heels of forty straight months of declines in the domestic producer price index. Whereas the oil story is mostly (not entirely) about supply, the plight of industrial metals has more to do with demand. And weaker demand from China has hit the export accounts of other emerging markets. It should come as little surprise that the MSCI Emerging Markets index is off by more than 12 percent from its June highs.
All That (Doesn’t) Glitter
Then there is gold. It would be fair to say that the gold bugs who went running for the hills in 2009, worried about the inflationary tinderbox the Fed was supposedly opening with its quantitative easing programs, have not been rewarded for their excessive caution. But at least gold was a part of the “risk off” trade back in 2011 when we had our last really big pullback in equities. Fast forward to July 2015, with Greece once again on the front pages and consensus forming around the idea that a breakup of the Eurozone is a matter of when, not if. Over the course of this month, with Greek banks shutting down and Chinese stocks plunging into bear territory, the price of gold actually fell by six percent. This is perhaps a useful reminder of something we have said from time to time on the pages of these weekly commentaries. There is nothing magical or mythical about gold. It is a commodity, with a price that goes up and down like any other commodity. Lately, the movement has been mostly down.
Trouble Ahead, Trouble Behind
Unfortunately for gold bugs, oil bulls and any other species looking for commodities gains to ring out the year, the road ahead does not look much more promising than the road behind. First of all, neither the oversupply of oil nor the slowing of growth in China look set to end any time soon. Those headwinds are likely to continue. Secondly, those headwinds are likely to compound further still if the Fed goes ahead with its rate program, as expected sometime between September and December. Higher interest rates impose a natural cost on holding commodities – after all, investors do not get any interest or dividend income from storing bars of gold or barrels of oil. Now, if a rising Fed funds rate signals a faster tempo to global real economic growth, we would expect that growth to translate into higher commodities prices at some point. From where we stand now, though, that “some point” still seems to be some distance away.