Posts tagged Stock Market Volatility
Let’s go back in time exactly one year – to June 14, 2018. Someone from the future visits you and tells you that in the first four months of 2019 – from the beginning of January to the end of April – the S&P 500 will rise by 17.5 percent. The future-visitor then beams out, leaving you with just that one piece of information and a portfolio strategy to plan. What would you assume about the world at large? That gain in US large cap equities is one of the strongest on record, so you would probably be inclined to imagine “risk-on” as the dominant sentiment in global markets. A healthy allocation to core equities and higher-risk satellite classes like small cap and non-US emerging markets would be a plausible strategy, while perhaps reducing core fixed income weights to the lower end of your approved range.
No Reward for Risk
Of course, being in possession of just that one snippet of information about the future means that you wouldn’t have known that stocks came within a whisper of ending their decade-long bull market in December 2018, or that the Fed would make a sudden and radical U-turn in January towards a more dovish policy stance. Even so, one of the noteworthy things about the 2019 incarnation of the equity bull is how confined it is to US large caps, while riskier asset classes have sputtered. The chart below illustrates this divergence between bonds and large cap stocks on the one hand and everything else on the other.
From that point in time one year ago both US small caps and non-US emerging markets are down around 10 percent – still in or close to a technical correction. Non-US developed markets haven’t fared much better, in part due to the translation effect of a strong dollar on foreign currency assets. So a broad-based risk-on mindset has never really set in. The star asset class for this period, particularly when looked at on a risk-adjusted basis, is fixed income. The US Aggregate Bond index is up low-mid single digits for this period, performing a little better than large cap value equities and just a bit behind large cap growth stocks but with much less volatility, as clearly seen in the chart.
Bonds are in favor largely because the market has talked itself into believing that a forthcoming economic downturn will necessitate aggressive action by the Fed and other central banks (the presumed downturn being global in nature and in fact catalyzed more by flagging economies outside the US than here at home, at least for now). But there is a twist here within the friendly confines of the fixed income space. If economic conditions really are set to turn down, then a logical assumption would be that credit risk spreads start to widen. But that has not happened. Investment grade corporates and high yield issues alike are holding up just fine. The iShares iBoxx High Yield Corporate Bond ETF is up around 6.4 percent in total return for the year to date.
So here’s the picture: while the market is definitely not in a “risk-on” mindset, as evidenced by the poor performance of many higher-risk asset classes, neither is it completely “risk-off” as shown by those healthy returns for large cap stocks and the absence of credit risk spread widening. It’s as if there is some arbitrary line, on the one side of which are assets thought to be protected by a dovish Fed, with the other side being for assets vulnerable to the full-on effects of a worsening economy.
In recent commentaries we have argued that this odd arrangement is not sustainable. At some point either we realize that the economy actually is stronger than expected – in which case asset classes should revert to a more traditional risk frontier (higher return for higher risk) – or that a global recession is indeed imminent, in which case the market goes full risk-off, credit spreads widen and large cap equities get their comeuppance.
But there is an alternative view, which appears to be the one embodied by today’s conventional wisdom. This view holds that the magic of central banks will continue to work well enough to keep the worst of a downturn at bay. In this world, holding a handful of traditionally higher-risk assets like large cap US equities and low investment grade / high yield bonds makes sense, but taking on additional risk from other asset classes doesn’t pay (since the source of market return is permissive monetary policy, not organic economic growth). To be perfectly honest we think this is a risky view with the potential for serious mispricing of certain asset types. But it’s 2019, folks, and strange is the new normal.
In our annual market outlook back in January (wait, is it already Memorial Day weekend?!) we had two principal things to say about volatility. First, that we expected to see a higher level of volatility as one of the key defining characteristics of risk asset markets in 2019; second, that volatility is not always associated with downward trends in asset prices (meaning that higher volatility could be present in both up markets and down markets). How has that prognostication played out so far this year? As we head into the summer season it seems a good time to revisit our January musings.
Peaks, Valleys and Mesas
Those of you familiar with how we have described volatility in the past will have encountered our topological renditions of the VIX index of market volatility, commonly known as the market’s “fear gauge.” Briefly, we have intermittent peaks when risk levels suddenly spike into the heavens like so many Gothic spires, and we have calm undulating valleys when investor attitudes are serene. And then we have mesas – extended periods where volatility is elevated but not as dramatic as those short spikes. The chart below provides a full rendering of this VIX topography over the market cycle of the past three years. In this chart the VIX is represented by the dotted green trendline, while the solid blue line shows the price trend movement for the S&P 500.
The peaks are pretty straightforward: they tend to happen when equity prices go into a tailspin. The most prominent risk spikes over the past three years, unsurprisingly, coincided with the sudden correction in stock prices in February 2018 and again in fall-winter of the same year. Those earlier, smaller spikes you see in 2016 coincided with the Brexit vote and the run-up to the US presidential election in the same year. Of course, in the aftermath of that election and throughout most of the following year investor sentiment was for the most part calm, and we experienced a long volatility valley that wound up setting successive new lows for the VIX throughout the summer and fall of 2017.
The mesas – that third topological element – figures into the interim period between the market correction spikes of February and October-December 2018, and again in the period since. Here we circle back to those comments about volatility we made in our January annual outlook. Higher volatility has indeed been a characteristic of asset markets this year, even though the overall price trend for most asset classes has been resoundingly positive. You can see that the VIX mesa between January and May 2019 is somewhat more elevated than that of April – September 2018, with more time spent above the long term average of 14.22 for this entire three year period. We think this is consistent with the contextual themes we discussed in our outlook: expectations for slower growth and a tougher set of comps for corporate earnings and margins, along with continued uncertainty about global trade. The mesa probably would have been higher still had not the Fed turned abruptly on its monetary policy towards a more dovish stance, with no more rate hikes in the foreseeable future.
Wider Intraday Spreads
The VIX, of course, is not the only way to look at risk and at times it can be misleading. VIX contracts are traded, bought and sold like any other asset, and as such what the index may be telling you on any given day can have more to do with flighty investor sentiment than with the underlying risk properties of the assets themselves. One such risk property is the intraday spread – the magnitude of difference between a stock’s intraday high and low price, expressed as a percentage of the closing price. In the chart below we show the intraday trend for the S&P 500 between August 2017 and the present.
Here’s how to interpret this chart: it shows the number of trading days each month for which the day’s intraday high-low variance (HLV) was greater than the average HLV for the entire period. For the entire period measured, the average HLV was 0.89 percent, meaning that the price difference between the high and the low was 0.89 percent of the closing price. So for any given day, if the HLV was higher than 0.89 percent that day was counted in that month’s tally. For example, in each of the months of September, October and November 2017, there was only one day in which the high-low variance was higher than the period average. By contrast, in both October and December 2018 the daily HLV was higher than average for nineteen days (in other words, for practically the entire month).
How does this chart help us understand the current risk environment? Well, the average number of higher HLV days for the first five months of this year (through the 5/23 close) is 8.2, including double-digit HLV days in both January and May. Again we want to make the point that volatility can be elevated even when the market is going up – January 2019 saw one of the strongest monthly price gains on record for the S&P 500, but there was higher than average intraday volatility for fourteen out of twenty-one total trading days. Conversely, the twelve HLV days recorded thus far for May coincide with a more risk-off mentality for investors as they pulled back in the wake of new record highs in April.
We believe there continues to be good reason to expect higher volatility in the weeks ahead. Remember – that may be good volatility or bad volatility. Given the way stocks trade in the present day, driven largely by reactive short-term quantitative models, any directional price trends are largely at the mercy of the daily headlines. The collective wisdom of the market may determine that trade war fears are overblown and the Fed has its back. Or, the consensus may be that the Fed’s toolbox is already pretty low on new surprises and global developments are unnerving. Either way, we will be looking at the elevation patterns in those mesas to gauge how much more volatility may lie ahead
New fiscal quarter and same old bull market, or so it would appear. Which probably should not come as much of a surprise, given the veritable absence of anything markets would find new and newsworthy. The Fed pivot has come and gone, the trade war turned out in the end to be a paper tiger, economic growth is slowing everywhere but still positive. Corporate earnings will be weaker than previous quarters but probably not as weak as the dramatically ratcheted-down estimates of Wall Street analysts. The old parlor trick of outperforming a low bar is back in full force! Meanwhile, the Brexit extension to the extension to the extension (which you, dear reader, will recall we predicted back in January) was agreed to during the same week that we got to see a picture of an actual black hole, in space. No coincidence, surely, between those two events.
The Rule of 145 Days
So the good times continue…depending on your perspective. Year to date? Things are great. The S&P 500 is up nearly 16 percent (in price terms) since the start of 2019, which is one of the best starts to a calendar year, ever. Moreover, the intraday tempo of this rally has been relatively calm, with only a small number of instances where the index moved by more than one percent from open to close.
If you step back and take a wider view, though, the picture looks a bit different.
That 16 percent calendar year gain looks a bit different in the context of what preceded it: not just the sharp pullback of last autumn but a much longer trading period going back to January 2018. Here’s what has happened since the S&P 500 reached a then-all time high on January 26 of that year. There was a technical correction, followed by an arduous 145-day climb to a new record high (in August), then a bit more upward momentum to the record high of 2930 set on September 20. 135 days have passed since then, and now we are within striking distance of yet another record high (maybe, who knows, when the day count hits 145 again).
What this means in actual performance terms is that the S&P 500, as of yesterday’s close, had gained a grand total of 0.5 percent from that January 26, 2018 peak. That’s cumulative, not annualized. Zero point five percent is not the stuff of a robust bull. Arguably, this sixteen month period represents a distinct phase of the great bull market that started in 2009: a phase we would term “wait-and-see.” The previous phase was the exceedingly non-volatile stretch from November 2016 to January 2018 (which phase certainly qualified for the moniker “robust”), and before that was the Mid-Decade Pause (another wait-and-see period) that came on the heels of the Fed’s ending its last quantitative easing program in 2014 and persisted through summer 2016.
That 2014-16 period may be instructive. Below we extend that same S&P 500 chart shown above to encompass a longer time period, where this bull market’s distinct phases are evident.
Of course, and contrary to our tongue-in-cheek section heading above, there is no such thing as a “rule of 145 days.” But it does feel like we might be getting close to the end of this particular phase of the bull as the market closes in on a new record high. The question, as always, is what comes next. Recall that in 2016 there was not much in the way of a compelling case to make that would have predicted the bull run of 2017. The bond market for much of this year has been suggesting that slower times are ahead. But the tea leaves, as always, are subject to multiple interpretations.
The bond market has been an active place of late. The Fed’s monetary policy pivot back in January (and an even more dovish position in March), a tempered outlook on global economic growth and related concerns have sparked a broad-based bond rally, with falling yields across most fixed income asset classes. We have been getting a number of questions from our clients about how these dynamics affect the returns they are seeing in the fixed income securities in their portfolios. So here are some key things to keep in mind when you are reviewing the bond portion of your portfolio.
It’s All In the Math
One question that comes up frequently is what drives relative performance between similar securities (e.g., governments or corporates) with different maturities. Consider, for example, the Treasury market. The chart below shows the relative yield trends of the 10-year Treasury note, a key benchmark for intermediate term bonds, and the 2-year note, a popular proxy for short term issues, so far this year.
Two things jump out in this chart. First, the spread between these two bonds is relatively tight. Currently just 18 basis points (0.18 percent) separate the 10-year and 2-year yields. The second thing is that the relative movement of each yield has been remarkably similar: when one goes up so does the other, and vice versa.
But when you look at the total return performance in your portfolio you will notice that they are not the same, or similar, at all. For example, the total return for the iShares 1-3 year Treasury ETF (SHY) for the year to date as of April 4 was 0.88 percent. The total return for the iShares 7-10 year Treasury ETF (IEF) was 2.15 percent. Big difference! What gives?
Fortunately, the answer is very simple: it’s all about the math. Bond pricing is entirely and completely driven by math. It’s all about the rate of interest and the magnitude & timing of a bond’s periodic interest and principal payments. The math works such that, for any incremental change in interest rates, the price of a longer-dated security will change by more than the price of a shorter-dated security. So, to use the example of the 2-year and the 10-year bonds in the above chart, the same decrease in the rate of interest will cause the longer-term price to appreciate by more than the shorter-term one. That’s why, all else being equal, bonds with longer maturities (or effective duration, which is a measure by which we compare the relative effect of interest rate changes) have outperformed ones with shorter durations this year.
A Bond’s Purpose
If you knew that interest rates were going to go down for a long time then, all else being equal, you would want to position your portfolio to capture the benefits of longer duration. Conversely, if your vision of the future is one of rising rates, then you are interested in shorter-dated securities as a way to reduce interest rate risk. Of course, nobody can ever know for certain which way rates are going to trend (think, for example, of the Fed’s complete U-turn between its December and January meetings). The answer – or our approach, in any case – is to maintain a range of short to intermediate duration exposures with an eye to mitigating the risk of a sudden jump in rates.
Ours is a fairly conservative approach for the simple reason that for our portfolios, the fixed income portion is where you go for safety, not for outperformance. Bonds are for stability (predictability of the size and timing of income streams) and for cushion against the risks to which other asset classes – primarily equities – are exposed. And it is those riskier asset classes – again, not bonds – where we actively seek growth through capital appreciation.
The total size of our fixed income allocation may change – higher or lower as a percentage of total portfolio assets depending on our overall market and economic outlook. But you won’t find us aggressively chasing returns through active duration management, because that is not why we have bonds in the first place.
Every time the topic of “technical analysis” comes up in our weekly commentary, we need to begin with the customary disclaimer. There is nothing magical about the tools of the technical trade. 200 day moving averages, round numbers, head-and-shoulders formations – these are all silly things with no inherent meaning. BUT, they do affect short term trading patterns. Why? Because the 70-odd percent of daily market volume driven by algorithm-based trader-bots turns these whimsical flights of fancy into meaningful pivots around which markets go up and down. As per Arthur Miller’s “Death of a Salesman” – attention must be paid! We are paying attention this week because a trend is coming into view with potentially bearish overtones. Which may mean something or nothing at all, but it’s worth a look.
When Support Becomes Resistance
The long term moving average is a staple of technical analysis, with 200 days being a particularly popular representative of the species. In bullish times the 200 day average acts as a support level, while in a bear market it becomes a ceiling of resistance. We will illustrate this phenomenon with the chart below, showing a comparison of the last twelve months price performance on the S&P 500 as compared to the period from January to December in 2000 (the first year in the 2000-03 bear market).
That reddish line coursing across each chart is the 200 day moving average. In both time periods (2000 and today) you can see the specific instances when the index bounces off the moving average and resumes an upward trend (for example, May and July 2000, and April and May 2018). You can also see where the moving average becomes a resistance ceiling (October-November 2000 and November-December 2018).
This past week, the 200 day moving average seemed to work with surgical precision. On the back of an impressive six week rally starting just after Christmas, the S&P 500 closed Wednesday just 0.15 percent below the moving average. It then promptly fell back in Thursday and early Friday morning trading. Again – this may or may not mean anything significant. Perhaps it even rallies back up after we go to print with this piece – who knows? But the technical pattern of the market since last October is thus far looking less like a bullish resumption and more like settling into a more negative cadence. Short term traders will be inclined to read it as such and then the Copenhagen theory of markets comes back into focus: the observation affects the outcome. Negative feeds on more negative.
What Say the Fundamentals?
As much as technical indicators impact short-term market movements, though, it takes more than that to produce a full-on chronic bear. Fundamentals matter. Here, the current contextual environment allows one to take a glass half full or half empty approach. The half full contingent will point to the more or less unchanging stream of good headline macro data here in the US: a robust jobs market with inflation right around the Fed’s two percent target, and still-healthy levels of consumer and business sentiment if not quite as optimistic as a year ago. Based on the data at hand, the likelihood of a near-term recession in the US is quite low. That’s good news.
But wait, says the half empty crowd. Look at where the consensus is going for Q1 2019 corporate earnings. Back in September last year the consensus forecast for first quarter earnings growth was 6.5 percent according to FactSet. That same forecast today, a bit more than seven weeks away from the end of Q1, is negative 1.9 percent. Even if the usual “estimates Kabuki” games are at play, that is a big delta. The lowered estimates come from corporations lowering their guidance for expected earnings.
What is notable is that the consensus outlook on sales has not come down as much as earnings. This means is that companies are not yet too concerned about structural demand – sales are expected to grow around 5 percent in Q1, which is a healthy number. But it implies that profit margins are going to be squeezed by a combination of factors such as higher wages, higher interest rates and other factors giving less profit bang for each incremental buck of sales. That feeds back into one of the main “glass half empty” talking points of recent months, namely peak profit margins.
Tilting at Headlines
While the fundamentals are confusing and the short term technical indicators giving cause for concern, the market has reverted to grasping at daily headlines for directional guidance. For most of this year there has been enough meat on the positive headlines – the Fed put being back in play (as we wrote about last week), nothing particularly negative on the trade war front, no other sudden surprises – to keep the direction positive.
But a headline-driven market is inherently skittish. There’s not much more room in the Fed punch bowl for positive surprises – even if the Fed were to start actively signaling towards a near-term rate cut it would leave the market wondering just how bad the underlying situation is. Europe’s problems are coming back into focus – spreads between Italian and German debt, for instance, are resuming a notable widening trend. British government leaders seem to be trying their hardest to convince the rest of the world that they are the most inept bunch of chummy toffs ever to claim the mantle of governance anywhere (these days, a decidedly low bar). Where the market winds up at the end of this year is anybody’s guess – but we expect to see plenty more ups and downs along the way, with downside risks that are not going away.