Weekly Update: What are they talking about??

02-09-2018

No travel for me this week, as Federated held its annual sales meetings here in Pittsburgh. That’s a blessing, as I would otherwise be scrambling to figure out/explain what is going on in the market (as of this mid-afternoon writing, the Dow had recovered from an ealier 500-drop on Friday but was still headed for its worst week in nine years). The past week’s trading has been all about volatility, with the VIX jumping 21 points on Monday alone, the largest one-day move in its history—even 4 points more than the worst day during the 2008 panic. The action evoked memories of portfolio insurance, quant funds and high-frequency trading in past waterfall declines for good reason. The use of securitized products (futures, options, ETFs, etc.) that enable direct betting on volatility exploded the past few years as dealers adapted to strangely low volatility. So when the VIX started to move, dealers had to cover these bets, adding to the downward spiral. Even though this volatility trade is a niche market, preventing the sort of systemic 2008 meltdown fueled by highly used/highly levered collateralized debt obligations and structured investment vehicles, the issue now is how volatility product dealers used equity derivatives to hedge their exposure. Unlike oil, real estate or some other physical asset, volatility isn’t tangible—you can’t just sell it because it isn’t a thing. So a natural landing place for these hedges were short positions in S&P 500 options, which are inversely related to the VIX. It is the unwinding of this trade the market is working through and it will be an interesting test to see how soon and how robustly markets heal from this self-inflicted wound. Following past VIX spikes, the S&P experienced continued declines over the subsequent three months, suggesting this drawdown, whenever and at what level it ends, likely will be followed by a period of consolidation through the quarter.

For the last several years, as I have traveled the country, advisors said they were waiting for a pullback to add to stocks. I always replied that, while no one can make short-term market calls, any reasonable pullback would happen for a reason, one that would make our stomachs nervous. My stomach is nervous. After Thursday’s rout, I watched CNBC commentators try to explain why the market has corrected 10% in a very short time. Listening and rewinding and listening again, I wonder how many average American investors understand what they are talking about. One key to watch will be whether the 200-day moving average of 2,538 on the S&P holds, Weeden & Co. says. It was successfully tested during the June and November 2016 dips, and at its peak, the market was trading 2 standard deviations above it—a near-record overextension. The velocity of this move almost certainly suggests there will be more aftershocks, but it’s interesting to note that almost all the action in VIX futures has been in the short end. Longer-maturity VIX futures have been relatively subdued. If this move really was about rates and inflation as mainstream pundits have said, one would expect to see bigger movements in the longer VIX futures. This suggests the correction is not a rational discounting of negative developments in the real economy. The often-heard explanation, before volatility derivatives started taking the blame, was the markets feared higher yields, higher inflation and a tighter Fed. TrendMacro thinks every part of that is wrong. I agree!

Worries about inflation jumped with last Friday’s 2.9% increase in average hourly earnings, but the increase was mostly at the supervisor/manager level, up the most since the data started in early 2007. Earnings for production and non-supervisory workers, which covers roughly 80% of the labor force, rose a steadier 2.4% as trend labor costs remain subdued. Ten-year bond yields have barely budged this week. This is not about inflation worries! No one wants a repeat of 1987 and the “portfolio insurance crash” crash. What a shame if this “cause-free scare,” as TrendMacro calls it, alienates yet another generation of investors in the market and squelches the only recent revival of animal spirits. After January’s record inflows into stock funds, investors pulled nearly $31 billion out of stock funds in the five days ended this past Wednesday, the biggest one-week withdrawal in more than a decade! If this pullback has to do with hedge funds and speculators “selling what they can” and little to do with worries about inflation, I will believe that regulations will tighten in an attempt to prevent a present-day crash precipitated by derivative securities blowing up. For the markets this year, I am worried about inflation and the Fed. If I am correct and the Fed is watching the stock market, along with its required objectives of targeting employment and inflation, this market volatility will slow their tightening plan. The silver lining!

Positives

Services surprise The ISM nonmanufacturing index unexpectedly jumped to near 60 in January, a high not seen in more than a decade, on new orders and employment. This indicates that domestic demand conditions and private-sector service jobs are strong and supportive of the past few quarters’ acceleration in GDP growth.

Global acceleration Despite higher prices, prolonged delivery times, inventory shortages, scarcity of labor and a looming threat of inflation, PMI surveys around the world collectively are enjoying an extraordinary expansion as all 18 advanced a third consecutive month in January. By any standard, the business surveys indicate more fast-paced global growth in 2018, with the eurozone, the U.K. and the U.S. the strongest players.

The consumer is spending Citing increased jobs, rising incomes and growing consumer confidence, the National Retail Federation forecast retail sales to rise a robust 3.8% to 4.4% this year. January got the year off to a decent start, as chain-store sales were relatively upbeat. Consumer credit for December also jumped, rising at a 6.2% annual rate. And Main Street didn’t seem to be bothered much by Wall Street’s woes, as Bloomberg’s weekly gauge of consumer comfort just slipped off its long-term highs.

Negatives

If we’re ever going to get inflation this will be the year Initial jobless claims fell more than expected in the latest week, dropping the 4-week average to a 45-year low. Feeling confident they can find better opportunities elsewhere, the number of workers voluntarily leaving their jobs also continued to rise in December. With economic growth shifting higher, this tightening labor market—Q4 marked the first time in this recovery that the pace of nominal GDP growth surpassed the jobless rate—is exacerbating worries about potential increases in labor costs and inflation.

Trade’s drag worsens The nation’s trade gap hit a 7-year high in December and rose 12% for all of 2017 as a welcome surge in exports (aided by a weak dollar) was overwhelmed by an even larger increase in imports, led by industrial supplies and materials. The gap with China hit a record and accounted for nearly half of the goods deficit. The larger-than-expected gap will detract from Q4 GDP when it is revised.

Trouble watch The Bank of England this week signaled a rate hike is coming soon, the European Central Bank appears on the verge of quantitative tapering and the Fed is stepping up its balance-sheet reduction program. All of this threatens to cause central bank liquidity to fall sharply this year, which would be an abrupt end to years of galloping ahead. If this occurs, it will make 2013’s Taper Tantrum look like a walk in the park.

What else

It’s all about the VIX Volatility measures for assets other than equity have remained relatively low, indicating that there is little sign of a broad-based market panic. Indeed, the VIX continues to be the asset in the epicenter of current market gyrations, with far larger moves than other measures of implied equity volatility.

Hmm. Robo-advisors haven’t had much experience with market routs and that was apparent this past Monday, as websites of 2 of the country's biggest robo-advisory firms crashed during the market’s steep sell-off. Complaints quickly spread across the internet from people who had trouble logging onto their accounts. The glitches represent a setback for a niche of the financial market industry that has been booming of late.

Midterm watch In 14 of 16 midterm elections since 1954, the president’s party has lost seats; the exceptions were  in 1998 when the GOP overplayed its hand on impeaching President Bill Clinton, and 2002, when President George Bush’s approval rating was high in the wake of 9/11. And when the president’s approval rating has been below 50%—President Trump’s current rating is around 42%—36 House seats have been lost to the opposition party on average. Democrats need a net gain of 24 seats to recapture the House.

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