Posts tagged Stock Market Volatility
Something interesting happened earlier this week – well, interesting for those who like to read meaning into round numbers. The number in question is 2, as in 2.0 percent, as in the yield on the 3-month US Treasury bill reached on July 18, the first time this widely used proxy for “cash” breached 2 percent since before the 2008 recession. The practical impact of this round-number event, though, is that it extends a trend underway since April; namely, that the yield on cash is now greater than the dividend yield on large cap stocks. The chart below shows the spread between the S&P 500 dividend yield and the 3-month T-bill over the past 5 years. After a yawning chasm for much of the post-recovery period when interest rates were held close to zero, the Fed’s monetary tightening program begun in late 2015 has now closed and reversed the dividend-cash spread.
Meet the New Spread, Same As the Old Spread
There is nothing unusual about cash returns exceeding the dividend yield; it is usually a feature of a recovery cycle. For example, over the course of the growth cycle from 2003-07 the yield on the 3-month Treasury bill was 3.0 percent, compared to a dividend yield on the S&P 500 of 1.7 percent. As we have often noted in these commentaries, though, this most recent growth cycle has been profoundly different. When short term rates started trending up at the end of 2015 the recovery was already five years old. It’s unheard of for interest rates to stay so far below dividend yields until nine years into the recovery.
But, of course, this was no accident. Rates were kept low in order to stimulate risk appetite after the 2008 financial crisis. Essentially, the Fed induced investors to move into riskier assets by making it as economically unattractive as possible to invest in risk-free securities. The European Central Bank of course went even further – they made investors actually pay – via negative interest rates – for the “privilege” of holding Eurozone credit obligations.
Welcome to the Jungle
Now that investors can actually get something in the way of a return on their cash allocations, however modest, market pundits are raising the chatter volume on whether this signals a potential cyclical drift out of equities into safer investments (similar to the very much related concerns about the yield curve we addressed last week). Another way to put the concern is this: can equities and other assets with higher risk properties still be attractive without the explicit inducement by monetary authorities? We’re back in the market jungle and ready to test the survival skills of common shares in the wild, goes this train of thought.
As with any other observation made without the assistance of a fully functioning crystal ball, the answer to that question is “it depends.” What it depends on, primarily, is the other component of value in a share of common stock beyond dividends: capital appreciation. In the chart above, the capital appreciation variable is the dotted crimson line representing the price appreciation in the S&P 500 over this five year period. While getting close to 2 percent each year from dividends, investors enjoyed substantial capital gains as well.
What the spread reversal between cash and dividends does more than anything else is to put paid to the “TINA” mantra – There Is No Alternative (to investing in stocks and other risk assets). The calculus is different now. An investor with modest risk appetite will need to be convinced that the dotted red line in that chart above has more room to move upwards. The dividend component of total return is no longer free money – there is now an alternative to that with a slightly better yield and less risk. The rest will have to come from capital appreciation.
Now, we have argued in recent commentaries that the growth cycle appears durable, given the continuity in macro growth trends and corporate sales & earnings. The numbers still would appear supportive of further capital appreciation. But we also expect that the change in the TINA equation will have an effect on capital flows at the margins. Whatever money is still on the sidelines may be less inclined to come into the market. At the very least, investors on the sidelines skeptical of how much longer the bull has to run will have a better reason to stay put in cash. If enough of them do so it can become a self-fulfilling trend.
The transition from summer to fall is always an interesting time in markets, as a consensus starts to form around what the driving trends of the fourth quarter will be. There’s enough at play right now to make the stakes particularly high this year.
At the beginning of this year we foresaw the potential for a spike in volatility. For awhile back in February and March that looked like a prescient call. Now…maybe not so much. As the predictable humidity settles into the Potomac region it would seem that the only high-octane energy around here is coming from DC’s long-suffering sports fans, celebrating their hockey team’s recent Stanley Cup victory (go Caps!). Risk asset markets, on the other hand, would appear…well, not as risky as they did a couple months back. The chart below shows the CBOE VIX index, a popular measure of market risk, alongside the S&P 500 over the past two years:
Source: MVF Research, FactSet
As we have noted in other commentaries the VIX, as a tradable entity itself, does not necessarily portray an accurate picture of market risk, particularly those Andean spikes that appear out of nowhere when algorithms hit their tripwires and summon forth the legions of trader-bots. But stock indexes appear becalmed as well when looking at internal volatility measures like standard deviation. We’re not quite yet in the valley of last year’s historically somnolent risk levels – but we seem headed that way and not too far off.
Don’t Grumble, Give a Whistle
Why the complacency? Even as we write this, the vaunted group of developed economies that call themselves the G-7 appear to be having a serious failure to communicate. Trade war rhetoric has stepped up following last week’s imposition of steel and aluminum tariffs by the US on its supposed allies including Canada and the EU. Italy, as noted in our commentary last week, is grappling with a political crisis and potentially unstable financial situation. Geopolitics are on the front page with the US-North Korea summit in Singapore fast approaching, to say nothing of the uncertainty around the Iran nuclear deal, the North Atlantic Free Trade Agreement (NAFTA), and growing evidence of China seeking to extend its economic clout in Southeast Asia, Africa and Latin America. There are headlines aplenty (even ones that don’t have to do with Trump’s Twitter account or the musings of some or other comedian) that could keep investors fidgety – and yet they calmly whistle past the bad news on the way to the sunny climes of the volatility valley. The latest bout of buying has lifted the S&P 500 comfortably above the 50-day moving average resistance level, as the above chart shows.
Nothing Else Matters (For Now, Anyway)
Actually, there is a reasonable justification for this midyear complacency, which is that for all the daily noise, not a whole lot has really changed in the macro picture. And what has changed – a little more inflation, a lot more growth in corporate sales and earnings – has largely been benign or downright positive. The tax cuts enacted at the end of last year may have a deleterious effect on the deficit, but such effect will likely not be felt for several years (“several years” being roughly equivalent to “an eternity” in Wall Street-speak). The trade war, should it come to pass, will also likely tend to have a gradual rather than an immediate effect, particularly on the domestic economy.
As for geopolitics – well, the market is extremely proficient in ignoring geopolitical concerns until they actually happen. That’s not a recent phenomenon. British merchant banks were happily extending loans to their German clients in the summer of 1914, even after the assassination of Archduke Ferdinand in Sarajevo. The Great Trade War of 2018, so far anyway, is not conjuring up images of the Schlieffen Plan or entrenched battle lines along the Marne.
The S&P 500 is up about 3.5 percent (in simple price terms) for the year to date. Earnings per share for the companies that make up the index are projected to grow at around 20 percent for the full year, with top line sales coming in at a robust 7.5 percent. That’s pretty agreeable math, and a decent reason to think that a fairly low-vol summer may be in store.
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.