Posts tagged Market Corrections
We’ve sort of gotten into the habit of referring to the 2018 equity market pullback in the past tense, which is not technically correct as the S&P 500 still languishes around 7 percent below its late-January record high. But the sense of drama that accompanied those big plunges in February in March, alongside the breathless narrative of a global trade war, is no longer clear and present. Is it too early to do a post-mortem and contemplate what may lie ahead? That’s entirely possible – whatever the market decides to do on May Day and the rest of next week is as murky as always. Nonetheless, we have our forensic tools out and will do a little dissecting of the present state of things. As volatile as things have been, this has so far been a remarkably well-behaved little correction.
Highly Relevant Nonsense
Perhaps nowhere is this well-tempered aspect more visible than in the market’s price performance vis a vis its technical moving averages, particularly the 50-day and 200-day averages. Now, we have made the point before and we will make it again: there is nothing magical or transcendental about moving averages. They are just methodical calculations. But they are given relevance because short-term trading strategies make them relevant – another example of the “observation affects reality” phenomenon we have described in other recent commentaries. The chart below shows the year-to-date performance of the S&P 500 along with the 50- and 200-day averages, and also the yield on the 10-year Treasury (which we will discuss in further detail below).
The 200-day moving average often serves as a support level. Technical traders get worried when the market breaches this downside support and fails to reestablish a position above it. No such worries this time: the index breached the 200-day average a handful of times in intraday trading but only closed once below it. Enough of those algo strategies were wired to kick in at this level, and there wasn’t enough prevailing negative sentiment to push prices into further negative territory. This played out most recently during this past week.
Our takeaway message from this is more or less what we’ve been saying throughout this period; namely that the catalyzing X-factors of this pullback – first the inflation fears after the February jobs report and then the new US tariffs – weren’t convincing enough to detract from the background narrative of continuing global growth and healthy corporate earnings.
On the other hand, though, the S&P 500 has had a similarly hard time staying above the resistance level of the 50-day moving average. Sentiment then, while not bearish, is also not wildly bullish. Investors wanting to see a clear “W” shape emerging from the pullback may have to bide their time for a while longer, or at least until the momentum strategy funds that got burned in February have worked through all their pain trades and those moving averages become less relevant to the daily flow of things.
Stocks and Bonds: Not Quite a Pas de Deux
Another observation that’s done a few laps on the financial pundit circuit recently is the idea that stock prices and bond yields have been moving in the same direction for much of the year. Well, sort of. In the aggregate that observation is clearly not true: stock prices are struggling to break even for the year to date, while the 10-year Treasury yield is up sharply from where it was in early January. But the chart above does show some degree of correlation during different sub-periods, most especially in the first three weeks of January when they did seem to move almost in tandem. Yields also reverted to traditional safe haven behavior during the second (trade war) prong of the pullback in mid-late March.
The correlation pattern diverged more prominently during the S&P 500’s mini-retreat of late last week and the first half of this week. The 10-year yield spiked to puncture the 3 percent level for the first time since 2014. Meanwhile, stocks fell back as investors, digesting a healthy stream of corporate earnings, did their best impression of a bratty kid who didn’t get the exact Christmas present he was expecting. “Peak quarter” seems to be the phrase of the day: the idea that this is about as good as it will get, even though the hard evidence for that glass half empty conclusion appears sparse.
What’s the overall takeaway? There’s a whiff of 2015 in the air. In that year stock prices set a record high in May and didn’t break new high ground until June of the following year (ironically, in the immediate aftermath of the Brexit vote, go figure). Cautious sentiment – neither pessimistic nor optimistic – may keep share prices in a sideways pattern. Those silly moving averages may continue to restrain directional breakouts. This kind of environment often suggests a return to quality, where things like free cash flow and debt ratios actually matter again and careful stock selection can pay off.
Then again, none of that could be true. If there’s anything one learns over the days and years in this profession, it is to always expect the unexpected.
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.
On February 3rd the S&P 500 experienced its most severe pullback since the period from May 21 – June 24, 2012. Oddly, the magnitude of the pullback was exactly the same to within two decimal points: -5.76% in each case. Here at MVCM we use 5% as a marker for a pullback worth recording in our records of peak-to-trough movements going back to 1951. If the S&P 500 rallies by 5% or more without falling below the 2/4 close, then these Bobbsey Twins pullbacks will each merit a small, slightly amusing shout-out in the time-honored annals of Wall Street weirdness.
U.S. equities indexes may indeed bounce back for another rally, but we will not be surprised to see a return to more pullbacks, with greater magnitudes, than has been the case in recent years. The return of the periodic 10% correction, something we have not seen since 2011, is likelier to happen if something else comes back to the market that has been AWOL for a while: volatility.
Been Away For So Long
The above chart is something we have shared before with our Market Flash community: the volatility gap that has persisted almost without pause for the past two years. The CBOE VIX index, fondly referred to as the “fear gauge” by Street pros, had an average closing price of 14.2 in 2013 versus the long term average of 20.2 going back to the index’s inception in 1990 (a higher VIX price means more volatility). Even 2012, a relatively tame year with no 10%-plus corrections, had an average VIX level of 17.8. Those spectacular returns of 2013 came with relatively little risk.
In finance, as in other walks of life, what goes down eventually comes back up. Volatility will return; the question is whether that return is imminent or whether U.S. equities still have a couple big rallies left in them. We are increasingly of the opinion that the return will be sooner rather than later.
(Macro) Event Planning
One thing seems evident: we’re in one of those event-driven environments where meta-narratives rise organically out of the swamp of macroeconomic data points, corporate earnings releases and global goings-on in places like China, Turkey and Brazil. The meta-narrative of late has been decidedly negative. Emerging markets currency crises have prolonged the pain for investors with long exposure to what are looking less and less like the “growth engines” of several years ago. That in turn has concentrated attention on the greatest growth engine of all, China. Concerns have bubbled under the surface for several years now about whether the world’s second largest economy can pull off the feat of defusing a potential credit bubble while rebalancing its growth away from increasingly speculative investment towards a healthier level of domestic consumption. The numbers coming out of China always must be taken with a measure of skepticism; nonetheless, a China-centered shock would have the potential to scorch a wide swath of asset class terrain.
Still Not Cheap
Meanwhile, the latest pullback has knocked about a point off the S&P 500’s next twelve months (NTM) P/E ratio, as seen below. But a pullback of a bit less than 6% doesn’t make for a screaming bargain when it comes on the back of a year of 30%-plus gains. At 14.4x, the NTM P/E is still above its 10-year average of 13.9x.
Indeed, the market’s recent success may amplify the negative tone of the prevailing narrative. With few investors expecting equities to deliver anything as spectacular as last year’s gains – especially the record-breaking risk-adjusted returns – and corporate earnings doing little more than to (mostly) beat downward-revised expectations, there may be an enthusiasm gap between the Pollyannas on one side and the Cassandras on the other.
So where does our -5.76% pullback go from here? Well, the S&P 500 closed 1.2% higher on Thursday, its biggest gain for the year to date. What that says about tomorrow, or next week, is anybody’s guess. But whether our scribes record -5.76% in the MVCM Pullback Annals or not, we are prepared for a volatile ride in 2014.