Posts tagged Stock Market Volatility
The unseen world is a very strange place. Quantum mechanics, the physics that describes the way things work at the subatomic level, has been validated as a scientific theory again and again since its discovery in the early 20th century. Quantum mechanical laws perfectly describe the workings of literally everything electronic and technology-related in our lives. For all its mainstream applications, though, the implications of quantum mechanics are positively exotic.
Particles exist here, there and everywhere. Pairs of entangled particles instantaneously affect each other across light years of distance. Single photons display wave interference patterns until observed, at which point the wave collapses into a particle with a definitive position in space. This act of observation informs the standard explanation taught to students of quantum physics. Known as the Copenhagen theory, after the home of pioneering scientist Niels Bohr, it posits that all matter exists in a state of superposition (i.e. here, there and everywhere) until observed, at which point it collapses into recognizable forms like trees, cute puppies and Bloomberg workstations. Don’t try to understand the deeper meaning of the Copenhagen theory. Bohr and his fellow pioneers didn’t. “Just shut up and calculate” is how they, and those following, have instructed every new generation of fresh-faced (and confused) physics students.
Don’t Look Now
The subtext of the Copenhagen theory – that observation creates its own reality – resonates in the present day world of stock market volatility. It has come as a painful lesson to investors who came late to the low-volatility party of late 2017 and took bets that the calm seas would carry on. The chart below shows the price trend for the CBOE VIX, the market’s so-called “fear gauge,” over the past twelve months.
When the VIX jumps in price, as it did towards the end of January, it implies a higher risk environment for equities. To look at the above chart is to surmise that something earth-shaking caused risk to jump nearly overnight as the calendar turned from January to February. And, yet, what actually happened? A jobs report showed that hourly wages had ticked up slightly more than expected in the previous month (2.9 percent versus the consensus estimate of 2.6 percent). An “inflation is back!” meme went viral and off to the races went the VIX. Pity the poor punter holding XIV, an exchange-traded note (ETN) designed to profit from a calm VIX. That ill-fated security lost 94 percent – not a typo – of its value in one day, and the ETN’s fund manager announced that the fund would shut down as a result.
Ninety four percent. On account of one lousy wages number. How could this happen? The answer, dear reader, lies in the observer. Risk is a statistical property, a measurement of variance in price. But – as we can see from securities like that poor XIV – it is also an object, a monetized claim. And that has deep implications for equity and other asset markets.
Goodhardt’s Law and the VIX
Charles Goodhardt was an economist who in 1975 made the following observation: “Once a measure becomes a target, it loses the very properties that made it a good gauge to begin with.” Goodhardt’s Law could also be called the Copenhagen Theory of Market Risk. Once you treat risk – volatility – as an object of buying and selling rather than just as a passive statistical measure, you distort what that measure is telling you. Referring back to the chart above, the world did not change in any meaningful way between Friday, February 2 and Monday, February 5. No macroeconomic statistic other than that one random wage number suggested that the economy had changed in any radical way. And yet if you held an asset on Friday morning betting on things staying more or less the same, you were wiped out by the end of the day the next Monday (even though things had more or less stayed the same). Fundamental risk hadn’t changed. But the perception – the observation – of risk created the reality of a 94 percent price drop.
This fact has profound implications for asset markets. The measurement of risk is absolutely fundamental to the models that have informed the construction of portfolios since Harry Markowitz and William Sharpe pioneered the concepts of mean-variance analysis in the 1950s and 1960s. When that measurement ceases to be a “good gauge,” in Goodhardt’s formulation, the ability to arrive at informed valuations for many other assets is itself at risk. Modern Portfolio Theory is the name given to Markowitz’s and Sharpe’s legacy. Increasingly, though, that legacy has to navigate a postmodern financial marketplace.
There are weeks when covering financial markets is interesting and engaging, where all sorts of macroeconomic variables and corporate business models demand analysis and discerning judgment for their potential impact on asset prices. And then there are weeks like this week, when none of those things seem to matter. “OMG Trump’s going to start a trade war and everything is going to be terrible” frets Ms. Market, just before the opening bell at 9:30 am. “No, silly, nothing’s going to happen, it’s just boys being boys, talking tough as always” say Ms. Market’s girlfriends while taking away her double espresso and offering some soothing chamomile tea instead. And so it goes, back and forth, up and down, day after tiresome day.
Soya Bean Farmers for Trump
We continue to believe that an all-out trade war between the US and its major trading partners is an unlikely scenario. But it has now been just shy of two months since the first announcement by the US administration of proposed new tariffs on steel and aluminum. The war of words, at least, shows no sign of fading into the background. Attention must be paid.
Moreover, the contours of the dispute have narrowed and hardened. Recall that the original steel and aluminum tariffs were comprehensive, drawing responses from all major trading partners. This week’s tough trade talk has been a much more bilateral affair between the US and China, starting with the formalization of $50 billion in new tariffs announced by the US on April 2. China promptly responded with its own countermeasures: $50 billion including major US exports like soya beans – a move that would go straight to the wallets of farmers in Trump-friendly rural America. Now here we are, on Friday morning, with the stakes raised to $100 billion after the latest US White House release. $100 billion represents about 20 percent of the total value of US imports from China. It would necessarily include many of the consumer products Americans buy – potentially suggesting a catalyst for higher inflation.
What Are Words For?
The message from the administration’s policy voices, such as they exist, to world markets has been essentially this: ignore our blustery words, they’re just harmless morsels of red meat for our rabid political base. All these tariff proposals, according to this line of thought, are just opening gambits for negotiation. Nobody really wants a trade war. This message was persuasive enough to bring Ms. Market out of her early morning funk on Wednesday. What was shaping up to be another one of those disheartening two percent-plus intraday plunges reversed course and finished north of one percent in the green column. We’ll see if the sweet talk is able to work its magic again today, with the S&P 500 back on the fainting couch during morning trading.
The other reason why markets may be inclined to not read too much into the playground tough talk is that actually executing a trade war would be far more complex than simply reading off lists of products and associated tariffs. The global economy truly is interlocked. What this means in practice is that trade is not anywhere nearly as simple as “China makes X, US makes Y and Germany makes Z.” Companies have invested billions upon billions of dollars in intricate value chains that start with basic raw inputs, go through multiple levels of manufacturing, wholesaling and retailing, and involve many different countries throughout the process. Dismantling these value chains, while theoretically possible, would result in an economy barely recognizable to the employees and consumers who have become used to them.
The earnings season for the first quarter is about to get underway, and it looks to be a barnstormer. FactSet, a research company, estimates that earnings per share for S&P 500 companies will grow around 17 percent year-over-year on average, which would make it the strongest quarter in more than 5 years (and, rationally, provide a nice tailwind for stock price valuations). The vast majority of these companies have absolutely no interest in being conscripted as foot soldiers in a trade war, and they will be sure to make their voices heard through plenty of influential lobbying channels. On the US side, at least, there is nothing remotely like a unified “team” suited up to do trade battle – and if they were to push the envelope further, they would almost certainly encounter more unity and clarity of purpose on the Chinese side.
In the end, the trade hawks in the administration may find a way to make do with a few cosmetic, harmless face-saving “wins” while quietly retreating from the battlefield. Meanwhile, though, we may have to put up with a few more of these irrational weeks in the market. Oh well. At least it’s springtime.
In the stock market, as in life, all is not equal. In the case of the S&P 500, the inequality derives from that simplest of mathematical formulas: share price times number of shares outstanding – i.e., market capitalization. The importance of any industry sector – from the standpoint of its influence on the total market – is simply a function of the market caps of all the companies in that sector added up. Simply put: the larger the market cap of an individual company or industry sector, the more impact their price movements have on the broader index.
Market Cap Economics 101
Investors have been getting a crash course in market cap economics over the past several weeks as the most dominant sector – and that sector’s most dominant constituents – have battled some unusually strong headwinds. Information technology – one of ten primary industry sectors in the S&P 500 – makes up just under 25 percent of that benchmark index’s total market cap. That is by far the largest single sector: financial institutions, the second largest, make up just 14.3 percent of total market cap at current values. Moreover, the four largest companies in the S&P 500 tech sector – Apple, Alphabet, Facebook and Microsoft – account for 11.1 percent of the total. Add in Amazon – widely considered a tech company although formally listed in the consumer discretionary sector – and you have five companies with a collective market cap of 14.1 percent of the S&P 500 – nearly as much as the entire financial sector. That explains why the following chart has so many investors on edge today:
The main tale of woe has centered around just one of these behemoths, Facebook, which is caught in the crosshairs of a rapidly evolving controversy over its data privacy policies. The story of Cambridge Analytica, a secretive data firm with an affinity for right wing politics and a 2016 mission to help get Trump elected, has been given thorough coverage in mainstream media outlets and does not need rehashing here. The issue is why this story, which at first glance would appear to be company-specific, has thrown such a wet blanket over the entire sector. As the chart above shows, the decline of the tech powerhouses in late January and early February was more or less in line with the market, while the sector’s decline in March has been relatively far more severe.
The answer is that, while Facebook has one business model, Alphabet (Google) another and Apple another still, issues like data privacy and network effects (which can potentially lock in users and lead to concerns about monopolistic practices) affect all the so-called “major platform companies.” In a sense, these recent developments are the flip side of the very reason for which investors have been in love with these companies for so long. Their platforms have radically changed the way a majority of Americans go about spending their days and nights. Actively managed investment funds, seeking that elusive (and probably illusory) “alpha” to beat the market, have swarmed into the so-called “FAANG” stocks like moths to a flame in the belief that these platforms are nearly impervious to competitive challenge.
Beware the Grim Regulator
If the tech heavies have in the recent past seemed like a free lunch, the recent travails are a reminder that free lunches don’t exist. Readers of US economic history know that the best laid plans of monopolists past have been dashed by regulatory push-back. It is by no means clear that a grim reaping is in store for the platform companies, but neither is it clear that they will continue to be given free reign to operate with no fundamental changes to their business models. As global companies, they are at the mercy not only of regulators at home, but arguably more antagonistic ones in the EU and elsewhere. It may be a stretch to imagine Facebook as a regulated utility (a theory which has surprisingly garnered considerable recent press coverage), but it’s worth remembering that strange things do sometimes happen.
In a practical sense, the uncertainty around tech adds a variable to the volatility equation that has become a constant companion in 2018. The CBOE VIX has not fallen below 15 since the original spike in early February, and currently hovers just around 20, the level considered to be a high-risk threshold. We’re seeing lots of those strange days when stock indexes spike up in morning trading and then plummet in the trading day’s final 30 minutes – signs of a jittery market with knee-jerk algorithms calling the shots.
Amid all of this, there is still little in the way of change to the dominant narrative of steady positive growth, a strong jobs market, solid corporate earnings and inflation kept in check. That may be sufficient to yet hold the downside in check. But those volatility variables, including the fog of uncertainty around that market cap-dominant tech sector, are keeping us very busy with our scenario analytics as the year’s second quarter beckons.
What a difference a year makes. For Exhibit A, consider the upcoming election this weekend in Italy. Wait, what? There’s an election in Italy this weekend? Must’ve missed that one…what with steel tariffs, Jared Kushner, incoherent crossfire between Trump and his own party on the issues of the day…only so much information one can consume, no?
The Way We Were
Other urgent media cross-currents notwithstanding there is, in fact, a national election in Italy this coming weekend. You would have known about it had it happened a year ago. Remember that time of slumbering volatility and gently ascending risk asset markets? Misty water-colored memories…There was an election in the Netherlands a year ago. The Netherlands is quite a bit smaller than Italy, GDP-wise, and it would be fair to venture that a not insignificant number of Americans would be hard-pressed to locate it on a map.
But for a few weeks in late winter last year the attention of global investors was focused on the outcome of elections in the land of dikes and canals. As in, it was about the only event on the radar screen that punters thought might unsettle the market’s placid waters, if it looked like the far right, anti-EU populist party would carry the day. It didn’t. A short time later the same singular focus turned to France (a larger country, the capital of which more Americans could probably name correctly).
Again, the far right threat failed to materialize as Marine Le Pen went down and Emmanuel Macron ascended as A New Hope (or, to the cynics, The Last (Classic Liberal) Jedi). The world resumed not caring about European elections. Oddly, the one the chattering class barely paid attention to, assuming the outcome was a given, was the German vote last September that produced a chaotic mess still in the process of being figured out six months later. The wisdom of crowds.
Two Matteos and a Clown Walk Into a Bar…
Which brings us to today, with Decision Italy about to happen amid a chaos of economic and geopolitical forces slamming markets this way and that with all the force of the Nor’easter currently having its gusty way with the DC region. Most of the same issues that concerned investors last year are very much front and center in this contest: neo-populism, anti-EU and single currency sentiment, hostility towards Middle East and North African immigration and, in this particular case, some disturbing reminders of Italy’s fascist history in the platforms of some of the leading political movements. The difference between this and last year’s elections is that a positive outcome – in the sense of being good for the EU, good for liberal democracy, bad for Russian meddlers – is actually the least likely one to happen.
That positive outcome would involve a decisive victory by the incumbent center-left Democratic Party (PD), which would probably mean the return of former prime minister Matteo Renzi, a EU-friendly technocrat inclined towards global free trade and the integrity of the single currency Eurozone. But the PD, similar to the fate of other established European center-left parties, has dropped precipitously in the polls. The likelihood of their winning a governing majority is vanishingly slim.
Enter the other two characters in our set-up to a bad joke: Matteo Salvini, the head of the far-right Northern League, and Silvio Berlusconi, the eternal court jester and sometime-leader of the Italian political scene. Berlusconi has cobbled together a right-leaning coalition between his own Forza Italia movement, Salvini’s League, a neo-fascist Brothers of Italy party and a southern alliance that calls itself “We’re With Italy” (if nothing else, Italy wins the Colorful Naming of Political Parties award). This unsavory coalition is the only political grouping with a reasonable chance at gaining majorities in either or both of the upper-house Senate or lower-house Chamber of Deputies come Sunday. If that happens, the next prime minister could very well be Mr. Salvini, who has personally referred to the euro as a “crime against humanity” and represents a movement founded on a northern Italian separatist agenda.
Chaos Has a Lean and Hungry Look
Slightly more likely than an outright win by the right is a hung election in which nobody gets a majority. That outcome could have the modest saving grace of keeping the current prime minister, the PD’s caretaker Paolo Gentiloni, at the helm for awhile longer while the various interests try to cobble together a grand coalition. But this result also does not bode well for the country or for regional stability. Italy’s debt to GDP ratio is already 130 percent, and the various public programs floated by the parties most likely to be in some form of power stand to add considerably more. Italy’s borrowing costs will be challenged as the ECB steps back from its full-throttle support of European bond markets. Global bond markets are already nervous this year; another Eurozone crisis would inflame an already investor-unfriendly environment. A competent response to economic challenges from any side looks unlikely.
For many months we have cited the “global macroeconomic context” as the main reason why we do not believe that a serious market reversal is right around the corner. The numbers continue to support that view today, despite the obvious return of long-dormant volatility among risk asset classes. But we also have to pay attention to the canaries in the coal mine – the factors that could loom ever larger as the current cycle plays out.
We know that much of the financial media world’s attention today is focused on the steel tariffs announced by Trump yesterday, and the (likely not unrelated) growing indications that the wheels are coming off this administration. Ultimately it will likely take more than one or two fumbling own goals to really take the nine year bull off its course. But there is evidence of a mosaic of chaos around the world – potentially including another Eurozone crisis, potentially including a China whose leader now possesses something close to absolute dictatorial powers, potentially including a whole new level of sophistication in global cyberterrorism. This mosaic of chaos is not (yet) showing up in macroeconomic headlines or in the steady stream of strong corporate earnings. But it is a mosaic we cannot ignore.
So, everything’s back to normal, right? The sharp pullback that began with the hourly wage number exactly two weeks ago has assumed its usual V-shape, with 5 straight trading days in the green following the technical correction level of minus 10.2 percent reached on February 8. Just like that silly Ebola freak-out back in 2014, this one looks like it will pass over, a brief squall yielding back to calm seas without so much as a full day spent below the 200-day moving average.
Yields Go North, Dollar Goes South
The good news, for those who prefer their equities portfolios neither shaken nor stirred, is that the continuing rise in bond yields is failing to inject fear into risk-on asset classes. The 10-year Treasury yield broke through 2.9 percent on Wednesday, even as the S&P 500 recorded yet another intraday gain of more than 1 percent. Those inflationary fears would seem tempered, even though Wednesday’s news cycle also served up a core CPI growth number a bit higher than consensus expectations. For the moment, anyway, the stock market seems comfortable enough with higher rates.
Which brings us to today’s big question: what is up with the US dollar? The chart below shows the downward trajectory of the dollar against the euro over the past six months, during which period the 10-year yield soared from just over 2 percent to the recent 2.9 percent.
All else being equal, rising rates should make the home currency more, not less attractive. Investors prefer to invest where returns are higher. Moreover, the dominant economic narrative around the US for the past half-year or so has been positive: above-trend growth, strong corporate earnings and high levels of business and consumer confidence. What’s not to love? Yet, even while the spread between the 10-year Treasury and the 10-year German Bund is 0.45 percent wider than it was six months ago the euro, as seen in the chart above, has soared against the dollar. And the pace has only accelerated since the beginning of 2018. Yes, the dollar jumped ever so briefly as a safe haven mentality took hold two weeks ago, but it fell back just as quickly – even while the 10-year yield reached new 4-year highs.
Supply and Demand, Yet Again
We’re starting to feel like Econ 101 professors around here lately, given how often the phrase “supply and demand” shows up in our commentaries and client conversations. We think it may be the single most important catchphrase for 2018, and in it lies a plausible explanation for that odd relationship between the dollar and bond yields. The supply-demand road inevitably leads back to China.
China’s central bank buys US government debt – lots of it. Chinese foreign reserves exceed $3 trillion, and the vast bulk of those reserves exist in the form of US government securities. Two things happen when Chinese monetary authorities (or any other foreign institution) buy US paper, all else being equal. First, the price goes up, and thus the yield, which moves in the opposite direction of the price, goes down. Second, the dollar goes up because Treasuries are a dollar-denominated asset. You see, it really is all about those supply and demand curves.
Recent evidence (including a weak Treasury auction last week) suggests that Chinese Treasury purchases are somewhat lower than they have been in recent years. That rumor back in early January, though quickly disputed, may have a kernel of truth to it. Foreign buyers indeed may have less appetite for Uncle Sam’s IOUs. Maybe they expect more inflation down the road (which would assume higher nominal rates). Maybe other factors are afoot. Whatever the reasons, reduced demand from non-US sources would indeed have the likely effect of pushing up rates and pushing down the dollar at the same time.
If this is the case, then we may be in for more bumpiness in equities. The S&P 500 digested the move to 2.9 percent very smoothly. We may see in the coming weeks whether the story plays out the same way at 3 percent or more. There will be a truckload of Treasuries coming down the road as we borrow to fund all that new spending and those tax cuts. More supply, in other words, potentially chasing less demand.