Posts tagged Stock Market Volatility
The equity market bulls had been running for more than five years. Over this time interest rates had come down dramatically, inflation was muted and most every fiscal quarter delivered a reasonably predictable uptick in real GDP growth. Markets had weathered a spate of political and financial scandals, as well as occasionally unnerving geopolitical flashpoints. All in all, there seemed to be no particular reason to complain or worry as summer transitioned to fall. Yet investors were edgy. A certain element of caution held in check what should have been giddy times on Wall Street, as if traders and investment bankers, contemplating their seven and eight figure bonuses, couldn’t shake the feeling that it was all a bit unreal. It’s quiet in here, said the young MBAs at Morgan and Salomon to each other as they stared at the monochrome numbers flashing silently on their Quotrons. It’s too quiet.
The previous paragraph could easily be imagined as some future market historian recalling the strange bull market of 2017 – up to the last sentence, anyway. Salomon Brothers is long deceased, and the cathode ray tubes of yesteryear’s Quotrons lie dormant in landfills, patiently awaiting the archaeologists of future millennia. No, the year in question is 1987. On October 19 of that year, a sudden flash of lightning made a direct hit on US equity markets. Major market indexes fell more than 20 percent in one day – the technical definition of a bear market. On October 20, market pros stumbled around the canyons of lower Manhattan asking: What happened?
Thirty years on, another generation of markets pros -- contemplating another secular bull amid low interest rates, steady economic growth and uncomfortably subdued volatility – asks a different question: could it happen again?
A Bear By Any Other Name
The chart below provides a quick snapshot of the Black Monday carnage – and the quick recovery thereafter.
That vertigo-inducing plunge on October 19 put the stock market squarely in bear territory, after a bull run that began in August 1982. But look how quickly the market recovered. By July of 1989 the S&P 500 had regained its pre-crash high. This new bull would go on running for more than a decade, ending only with the bursting of the tech bubble in 2000. For this reason, even though the 1987 market crash was technically a bear market event, we describe it in conversations with clients more as a disruption in the Great Growth Market that ran for 18 years (from 1982 to 2000). We think it is important to make this distinction. Secular bear markets, like the 14 years between 1968 and 1982, call for specific portfolio strategies. But there is very little that one can do about a sudden pullback like Black Monday. To respond to that question we identified above – could a 1987-style event happen again? – our answer is yes. Most certainly it could, and in the next couple paragraphs we will share our thoughts as to why. But a pullback based on some one-off exogenous risk factors – however steep – is not the same thing as a true bear market.
Portfolio Insurance: “Algo” Trading’s Beta Version
So what caused Black Monday? It took quite a while for the market experts of the day to put the pieces of the puzzle together, but in the end they identified the culprit: portfolio insurance. This seemingly benign term encapsulated an approach to institutional portfolio management that involved computer-driven signals to act as warning bells when market conditions appeared risky. Sound familiar? It should, because the crude hedging strategies that made up portfolio insurance circa 1987 were the ancestors of today’s ultra-sophisticated quantitative strategies known by those in the game as “algo” (for “algorithm”) trading.
If you look at the chart above you will see that, a few days before Black Monday, the stock market moved meaningfully lower after soaring to new record highs. For a combination of reasons involving the rate of change in the market’s advances and declines, underlying volatility and a few other factors, the portfolio insurance triggers kicked in and began selling off positions to build hedges. On October 16, the Friday before the crash, the S&P 500 pulled back more than 5 percent as the hedging begat more hedging. On Monday morning the sell orders cascaded in, but there were no buyers. That’s what brought about the carnage.
Peaks and Troughs
Given how much money is currently invested in the offspring of portfolio insurance, the really interesting question is not “could it happen again?” but rather “why hasn’t it happened more often?” For one thing, the ’87 crash did bring about some institutional reforms – operational circuit-breakers and the like – to try and minimize the damage a tidal wave of one-directional orders could bring about. These safeguards have worked on a number of occasions.
For another, the vast diversity of quantitative strategies itself is a kind of check and balance. Every algo program has its own set of triggers: buy when the German Bund does X, sell when Janet Yellen says Y, write a bunch of straddles when China’s monthly FX reserve outflows top $100 million. Put all these out there in the capital markets and they act sort of like the ocean when the peak of one wave collides into the trough of another – they cancel each other out. But that is reassuring only up to a point. It is not hard to imagine that a perfect storm of signals could converge and send all the algo triggers moving in the same direction – everyone wants to sell, no one wants to buy. Crash!
Lessons from the Crash
So, if such a perfect storm were to happen and blindside portfolios with massive short term losses, are there lessons to be learned from 1987? Quite so. It should be clear from the above chart that the worst thing an investor could have done on October 20, 1987 would have been to sell in a panic. In fact, those of us who have been at this long enough to remember the day (and do we ever!) recall that Wall Street’s trading rooms were never more frenzied with buy orders than in the weeks after Black Monday. Portfolio managers may not have yet known exactly why the crash happened – but they knew that the macroeconomic context hadn’t changed, that there were no new geopolitical crises, and that stocks with stratospheric P/E ratios after a long bull run were suddenly super-cheap. That, largely, is what explains the quick recovery, explains why 1987 was not a “real” bear market and explains why, all else remaining more or less unchanged, the prudent response to an out-of-the-blue event is to stay disciplined.
Talk of endurance is all the rage these days. Fall race season looms for runners and triathletes contemplating their next attempt at 26.2 or 140 or whatever mileage benchmarks await the end of the arduous training programs through which they (we!) have been slogging all these humid summer months. In markets, too, endurance is the word of the moment, and not just in stocks. Sure, we’re into the ninth year of the equity bull market that began in March 2009, which counts by most calculations as the second-longest running bull on record. But that pales in comparison to the granddaddy of all distance runners. The bond market produced yields in the stratospheric heights of 20-odd percent in 1981, then rallied as the Fed broke the back of double-digit inflation. We’ve been in a bond bull ever since.
New Challengers Emerge
Alongside these elite harriers we have a couple other asset classes looking to break through more modest distance goals. The long-beleaguered euro limbered up back in January and started to chase its longstanding nemesis, the US dollar. The euro is up around 16 percent versus the dollar year-to-date, a surprising turn of events for those caught up in the hype of the so-called “Trump trade” that followed the election last November. In commodity-land, copper and other industrial metals have gained more than 20 percent. While the China demand-fueled “supercycle” for commodities is deemed long dead, the future for a select group of metals, including copper, may well be bright if forecasts about the demand for lithium ion batteries (key components of electricity-operated vehicles) prove to be accurate. For the moment, non-US currencies and industrial metals are still microtrends, unproven at longer distances, but it will be worth keeping an eye on their progress.
A Flat & Forgiving Course
Distance runners tend to do their best work on predictable, smooth courses with a minimum of steep hills or unexpectedly rough, slippery terrain. Which brings us back to stocks and the nine-year bull. There really haven’t been too many Heartbreak Hills since the summer of 2011, when the simmering Eurozone crisis and the US debt ceiling fiasco took stocks into a vortex that stopped just short of a bear-level pullback of 20 percent. The tailwinds have come courtesy of the central banks and their monetary stimulus programs, along with an economy that has delivered steady, if modest, growth, an improved labor market and muted inflation. Corporate earnings have done well in this environment, so that even if stocks are expensive by most valuation standards (they are), they remain well below the bubble levels of the late dot-com era.
Now, anything can disrupt the equilibrium at any time. There are always risk factors lurking under the surface that, if actualized, would create havoc in asset markets. Think back to the longest bull on record: that of 1982-2000. Technicians would dispute our labeling this entire period a bull market, as it was punctured by the sudden cataclysm of Black Monday 1987, when the Dow and other major US indexes fell more than 20 percent in one day. We don’t think of the 1987 pullback as a bear market in the classic sense, though, because (a) it was entirely unrelated to broader economic trends, and (b) it was over almost as soon as it began. The 1987 event looked nothing like the last real bear market, a long stretch of misery that endured from 1968 to 1982. We bring this up because, based on everything we see in the economic and corporate profits landscape today, any potential pullback in the immediate future would more likely arise from the sudden emergence of a hitherto dormant risk factor than from a structural change in conditions. The course, in other words, remains flat and forgiving, but runners should always be aware that lightning can strike.
Even Ultramarathoners Tire Out
And that, in turn, brings us back to that superstar distance runner, the bond market. Because if anything could potentially make that flat course hillier and more unpredictable, it would be an end to the “lower for longer” assumption about bond yields that is baked into every asset class with a risk premium. The risk premium for any asset starts with interest rates; namely, the prevailing risk-free rate layered with additional quanta of risks deemed pertinent to the asset in question. Upsetting the applecart of low rates would reverberate throughout the capital markets in a uniquely pervasive way.
For now, the bond market would appear to still be a ways away from its last legs. Both the Fed and the ECB will likely try to provide reassuring guidance over the course of this fall as to how they plan to move towards a more “normal” monetary policy environment with a minimum of disruptive surprises. We don’t expect much disruption to ensue from the upcoming September meetings of either central bank. But we have to pay close attention to any unusual wobbles or other signs of fatigue along the way.
Jackson Hole is, by all accounts, a lovely redoubt, high up in the Rocky Mountains of Wyoming. As has been the case every August since 1978, the monetary mandarins who set the agenda for the world’s central banks will dutifully traipse up to this hiking and skiing paradise next week for their annual economic symposium. The attention span of the global investment community will briefly train its attention on Jackson Hole, and not on account of the riveting topics on tap for keynote speeches and panel confabs. This year’s symposium title is “Fostering a Dynamic Global Economy,” an anodyne and, in this contentious day and age, somewhat wistful formulation. If nothing else, though, it at least rolls off the tongue more easily than last year’s unfortunate word salad of a lead line: “Designing Resilient Monetary Policy Frameworks for the Future.” Central banker says what?
Euron a Roll
No, investors’ interest in the proceedings will be strictly limited to whatever policy utterances may spring forth from the lips of bankers, none more so than European Central Bank chief Mario Draghi. A frisson of anticipation rippled in late June from Draghi’s musings about the stronger than expected pace of recovery in the Eurozone. These musings, not unlike Ben Bernanke’s “taper” kerfuffle of May 2013, sent bond markets and the euro into a tizzy as investors imagined the beginning of the end of Eurozone QE. The euro in particular went on a tear, as the chart below illustrates:
So much did the currency respond to fears of a more aggressive QE taper by the ECB that a strong euro has replaced a strong Eurozone as the central bank’s chief concern, as revealed by the most recent ECB minutes published this week. The euro’s strength puts regional companies at a competitive disadvantage for their exports, and complicates the ECB’s elusive target of 2 percent inflation. The characteristically cautious and incremental Draghi is thus likely to be on his guard to avoid any comments that could be interpreted by the market as hawkish policy leanings. Those tuning into the Jackson Hole proceedings may well come away with little more than the bland sentences peppered with bursts of arcane math that make up the majority of central bank speeches. More likely, investors will have to wait until the ECB’s next policy meetings in September and October for guidance on the timing of QE tapering.
The Smell of Fear
Concerns about the euro come at the same time as a smattering of long-dormant volatility comes back into risk asset markets. The CBOE VIX index has found a new home above 15 in recent days – still below the commonly accepted fear threshold of 20, but well above the sub-10 all-time lows it has plumbed for much of the past several months. Global stock indexes have experienced some attendant turbulence in the form of 1 percent-plus intraday pullbacks – fairly tame by historical norms but enough to re-ignite the chatter about the duration of this bull market, expensive valuations and all the rest.
It’s been awhile since shaky asset markets have tested central bankers’ nerves. Nor is there any clear indication that this late summer volatility will develop into anything more than a brief passing thunderstorm or two. But we have sufficient evidence from recent history that the policymakers do react to asset prices. They will likely be wary of pushing too hard for normalization policies (tapering on the part of the ECB, balance sheet reduction and further rate hikes for the Fed) if they sense that such moves will feed into already jittery capital markets.
Chances are that the only “hikes” on the agenda at Jackson Hole will be the kind involving nature’s beauty, not interest rates. We don’t expect much from Wyoming to be moving markets next week. But the central bankers still face a dilemma: how to proceed with the normalization they so want to accomplish when (a) market reactions could be troublesome, and (b) the urgency from a macroeconomic perspective is not clear and present. This will be one of the key contextual themes, we believe, heading into the fall.
Should you be concerned about the somewhat bumpy ride US stocks have encountered in the past couple days? Or is this a welcome chance to get in some long overdue bargain hunting before the S&P 500 resumes its lazy upward drift to a series of new highs?
The answer would depend, we imagine, on whether you see the unrest on the Korean peninsula – arguably the best go-to explanation for yesterday’s 1.45 percent pullback in the US benchmark index – as something genuinely serious and potentially destabilizing, or as little more than a spate of made-for-Twitter taunts that will, as these things generally do, settle down. As you contemplate this, bear in mind that most of the intense geopolitical flashpoints in history (notably including the 1962 Cuban Missile Crisis) have had relatively negligible impacts on asset returns in the months following the event. We have noted before that disaster doesn’t strike far more often than it does strike.
Caveat Bargain Hunter
That being said – and our instinctive proclivity towards bargain-hunting notwithstanding – there are some reasons entirely unrelated to geopolitics that merit some thought before doubling down on your equity market exposure. This comes back to a theme we have discussed extensively with clients in recent weeks, namely, the rather listless, leaderless nature of the market’s upward drift this summer. Consider the chart below, which shows the relative performance of the main S&P 500 industry sectors against the benchmark index for the year to date.
In this chart we draw particular attention to three sectors: technology, financials and energy. These are the three sectors that were the key drivers of profit growth in the just-concluded second quarter earnings season. Energy led the way with a triple-digit earnings rebound from the depths of the sector’s miserable 2016. Technology and financials both enjoyed double-digit earnings growth and the tech sector’s top line was strong as well, helped along by the benign tailwind of a weaker dollar against major trading partners.
With the exception of tech, though, these earnings haven’t translated into share price performance. Energy continues to be the market’s problem child, seemingly unable to convince investors that the current trough recovery in earnings is sustainable. Financials, of course, were the darling of the post-election reflation trade before that ill-conceived flight of fancy crashed and burned in this year’s first quarter. Banks and their ilk have trailed the benchmark since then. And tech, even though it maintains a solid performance lead this year, has shown itself to be vulnerable on several occasions, most notably with that big pullback in early June.
The apparent lack of attention paid to earnings extends to the level of individual stocks as well. A Financial Times article earlier this week reported on the market’s apparent failure to reward companies beating their Q2 earnings estimates, noting that “there has been little or no reward for companies reporting better than expected earnings per share and sales.” This observation fits in squarely with our contention that, while the market drifts higher in the absence of a compelling negative headwind, it lacks a sustaining theme. And without such a sustaining theme the market is, we believe, more vulnerable to the types of external shocks we have seen this week.
Labor Day Looms
As we write this before Friday’s market open, we have no crystal ball to tell us whether yesterday’s pullback will extend for a few more days (S&P 500 futures are about flat with 20 minutes to go before the open). We haven’t seen a multi-day pullback for more than a year and a half, but they do happen with some regularity. We think it more likely than not that the Korea kerfuffle will subside in due time, playground taunts from both heads of state kept in check by cooler heads. But the listless market will still be exposed to these kinds of periodic shocks, and they may come into sharper focus as the traditional back to school season approaches. Yesterday the VIX, the market’s “fear gauge”, shot up above 17 after weeks of historically low dormancy. Until we have another compelling, sustainable positive trend narrative, we should not be surprised to see more of these periodic, brief solar flares.
From the beginning of January to the beginning of March, the S&P 500 set a total of 13 new record highs. Twelve of them happened after January 20, which no doubt made for an unhappy crowd of “sell the Inauguration” traders. Since March 1, though, it’s been all crickets. The benchmark index is a bit more than two percent down from that March 1 high, with the erstwhile down and out defensive sectors of consumer staples and utilities outperforming yesterday’s financial, industrial and materials darlings.
More interesting than the raw price numbers, though, is the risk-adjusted trend of late. To us, the remarkable thing about the reflation trade – other than investors’ boundless faith in the pony-out-back siren song of “soft” data – was the total absence of volatility that accompanied it. The reflation trade reflected a complacency that struck us as somewhat out of alignment with what was actually going on in the world. In the past several days, though, the CBOE VIX index – the market’s so-called “fear gauge” – has ticked above 15 for the first time since last November’s election. Half a (pre-holiday) week doth not a trend make – and the VIX is still nowhere near the threshold of 20 that signifies an elevated risk environment – but there may be reason to suspect that the complacency trade has run its course.
Equity markets have been expensive for some time, with traditional valuation metrics like price-earnings (P/E) and price-sales (P/S) higher than they have been since the early years of the last decade. But they remain below the nosebleed levels of the dot-com bubble of the late 1990s…unless you add in a risk adjustment factor. Consider the chart below, showing Robert Shiller’s cyclically adjusted P/E ratio (CAPE) divided by the VIX. The data run from January 1990 (when the VIX was incepted) to the end of March 2017.
When adjusted for risk this way, the market recently has been more expensive than it was at the peak of both earlier bubbles – the dot-com fiesta and then the real estate-fueled frenzy of 2006-07. The late 1990s may have been devil-may-care as far as unrealistic P/E ratios go, but there was an appropriate underpinning of volatility; the average VIX level for 1998 was a whopping 25.6, and for 1999 it was 24.4. Quite a difference from the fear gauge’s tepid 12.6 average between November 2016 and March of this year.
Killing Me Softly
In our era of “alternative facts” it is perhaps unsurprising that the term “soft data” took firm root in the lexicon of financial markets over the past months. The normal go-to data points we analyze from month to month – real GDP growth, inflation, employment, corporate earnings and the like – have not given us any reason to believe some paradigm shift is underway. Meanwhile the soft platitudes of massive infrastructure build-out and historical changes to the tax code have ceded way to the hard realities of crafting legislature in the highly divisive political environment of Washington. Survey-based indicators like consumer or business owner sentiment, which have been behind some of the market’s recent era of good feelings, are not entirely useless, but they don’t always translate into hard numbers like retail sales or business investment.
The good news is that the hard data continue to tell a reasonably upbeat story: moderate growth in output here and abroad, a relatively tight labor market and inflation very close to that Goldilocks zone of two percent. This should continue to put limits on downside risk and make any sudden pullback a healthy buying opportunity. But we believe that further overall upside will be limited by today’s valuation realities, with an attendant likelihood that investors will return their attention to quality stocks and away from effervescent themes. And, yes, with a bit more sobriety and a bit less complacency.