15 Feb Insights to the recent market volatility
WHAT is going on with this stock market?
On January 26 the stock market was sitting at an all-time high. Investors everywhere were marveling at what an impressive start to the year it had been—and what an astounding run stocks have had for the past nine years, adding more than 300% from their 2009 post-financial-crisis low. And, then, after this extended run amid a nearly unprecedented lack of volatility, the S&P 500 Index (large domestic stocks) suddenly fell 10% in a volatile past two weeks.
The questions are why, and what happens next?
In the interest of brevity I’ll first cut to the chase with a ‘Reader’s Digest’ version, and then expand the discussion for additional perspective.
Reader’s Digest Version:
Markets are sometimes volatile and, in the short-term, unpredictable. It is possible that markets will experience further declines. But it is possible that they won’t. The declines so far have been well within historic norms. Things could get worse, but if they do, they will likely recover. In the long–term the markets are more predictable—over time they typically go up. It’s human nature to lose patience and sell at or near the bottom of a downturn, but trying to time the markets is a recipe for failure. Even those lucky enough to get out early in a decline have to get lucky a second time by guessing when to reenter the market.
So what happened here? It seems that after years of wariness about equities, investors had finally thrown in the towel, pouring cash into stock mutual and exchange-traded funds. Suddenly rising interest rates are always a threat to equities and investors were paying little heed to warnings that higher rates (bond yields) would trip up the bull.
Yet, that’s just what happened. The 10-year Treasury yield surged 0.44 of a percentage point on February 2, to a four-year high of 2.85%. While still a low yield by historical norms, it’s the direction of yields that matters. In this case, yields jumped on the threat of higher inflation after the January payroll report, released that morning, showed that U.S. wage growth had increased by the highest monthly rate since 2009.
Much of the recent market environment – and the bull market itself – had been predicated on interest rates staying low.
In the years since the financial crisis, investors had grown accustomed to a world with low inflation and sluggish, but predictable growth. Corporate earnings benefited from those trends, too. But faster growth, greater inflation, and rising bond yields signal that this comforting world is a thing of a past. Economic growth is likely to pick up due to the passage of the new tax law, adding to inflationary pressures. The bet now is the Federal Reserve will continue to lift rates, and thus tighten credit, while the market worries that if they act too aggressively it could eventually lead to an economic recession.
Given the extended run-up in shares, the reaction to a change in sentiment has been swift. The abrupt change in mood was exaggerated in a big way by algorithmic program trading (“the machines”) as wealth is increasingly being managed by software programs that are programmed to sell when others are selling.
Violent corrections are unsettling and I will not attempt to call a bottom here, but a case can be made for an incredibly bullish fundamental economic backdrop. The confluence of events that caused investors to price in perfection remain with us: a synchronous global recovery, accelerated profits growth (even independent of the corporate largess in the new tax bill), still historically low interest rates, and benign inflation . . . . with leading indicators suggesting no sign of recession on the horizon for at least the next year.
Rather than worrying about short-term market swings, the more important thing for investors is to understand their near-term and on-going liquidity needs, understand the inevitability of market volatility, remain diversified with properly calibrated exposure, have a plan, and stick to it.
Let’s put the recent (on-going) stock market correction into context. The market appears to be returning to ‘normal’, just when people forgot what normal is. Given the extended run up in prices, we’re simply now in the midst of a long-overdue correction.
Research from JP Morgan can help us understand ‘normal’ in terms of average market volatility. It shows the average intra-year decline over the past 38 years (through 2017) was 13.8%. Thus, equity investors should expect every year or so to experience a pullback of similar magnitude at some point while appreciating that, by definition, half of the time the pullback will exceed – and half the time it will be less than – average. Even the negative action of the past two weeks hasn’t yet produced an even ‘average’ decline.
Sudden Jump in Interest Rates
The initial trigger for a sell off is often new information not already reflected in prices. Here it appears to have been higher interest rates resulting from the recent employment report showing faster than expected wage growth, which is bearish for bonds. Rates spiked (by .44%) on the news, continuing an upward trend. 10-year Treasury debt now yields 2.85%; it yielded 2.05% last July.
The Federal Reserve typically seeks to tame accelerating inflation by increasing interest rates, which leads to higher bonds yields. Interest rates also figure prominently in how investors value stock prices. As rates rise, sooner or later stock prices face headwinds for three main reasons. First, higher rates enhance the relative appeal of bonds in the competition for investors’ capital. Secondly, stocks are a long-dated asset which is ultimately valued by discounting the expected cash flows to owners (dividends). The higher the interest rate in a present value calculation, the lower the resulting value. The third problem with rising rates is company earnings (drivers of stock prices) are pinched by higher borrowing costs, while the new tax law limits the tax deduction for interest expense.
Neither is the bond market fond of rising rates, as long-dated bonds in particular lose value as interest rates escalate. Bond investors are lenders, and the US Treasury or corporate bond they purchased (loan they made) at, say, 3.1% interest for 30 years, loses value when general interest rates rise causing the same loan to merit, say, a 5.1% rate.
Equity investors adjusting to what appears to be a new interest rate backdrop may be a proximate cause for some initial selling. However, the selling was amplified by (i) a violent unwinding of the “short volatility” trade and (ii) investors exiting passive strategies.
‘Short Volatility’ Implosion
New and innovative investment tools facilitating bets that the environment would remain calm proliferated, and investors piled into these “short volatility” strategies at their highs. Consider: the S&P 500 recently went 310 trading days since that index last had back-to-back declines of .50% or more. That 15 month period is twice the prior longest streak.
Selloffs by their nature are inherently volatile. At perhaps stretched valuations the selling morphed into ‘machine selling’ which provided an abrupt jolt from euphoria and complacency. Low volatility bets (often leveraged) made money for six years before giving it all back in one day. Critics likening the value proposition of such strategies as “picking up nickels in front of a steam roller” were shown to be right. One takeaway: ‘trend following’ bets often work beautifully and for an extended period . . . . until they don’t.
Passive (Index) investment strategies also contributed to the sell-off. When these (often) ‘weak hands’ hit the sell button, they are selling an index which means indiscriminate selling of hundreds of companies at one time. In some respects this is akin to “throwing the baby out with the bath water” as worthy companies can and often are sold down to absurd prices, creating bargains for nimble, ‘active’ investors in the process.
Indiscriminate, across-the-board selling, whether by “the machines” or as a result of so much wealth in passive vehicles, is bound to produce bargains.
Thus, while equity investors adjusting to what appears to be a new interest rate backdrop may be a proximate cause for some initial selling, the investors exiting passive strategies and certain algorithmic program trading associated with an unwind of the short volatility trade overwhelmed the market.
Bullish Fundamental Backdrop Persists
As to a short and intermediate-term outlook for stocks, there will likely be more selling ahead as levered, wrong-way, bets on volatility continue to unwind and ‘weak hand’ investors exit indiscriminately. Violent corrections are unsettling and I will not attempt to call a bottom, but the case can be made for an incredibly bullish economic backdrop and that, from these levels, stocks have room to rise. The constructive setup remains with us: a synchronous global recovery, accelerated profits growth, still historically low interest rates and inflation, with no sign of recession in sight.
“Nothing has changed fundamentally . . . Interest rates have gone up but from a very low level. The change in interest rates has been basically a change in real [inflation-adjusted] rates rather than because of rising inflation.”
David Kelly, chief global strategies of JP Morgan Asset Management
So while the intermediate-term (12 months) looks to be in good shape, longer-term there are potential issues. There always are. Aside from ever-present geopolitical concerns, the world is truly awash in debt and our domestic stock market cannot continue to grow faster than our economy; income and wealth disparity is a real and growing economic problem.
Central Bank Liquidity and its Eventual Contraction
Asset prices have been buoyed dramatically by excess central bank liquidity (quantitative easing – artificially repressing interest rates by buying their own sovereign debt). The resulting low rates have directly benefitted the major advanced economies. For whatever reason (low population growth, weak productivity performance, aging demographics, debt burdens, etc.) economies need those ultra-low rates to achieve anything resembling full employment.
Total Global Debt – including that accumulated by governments, corporations, and households but excluding unfunded government liabilities (future promises) – is reportedly some $220 Trillion today, or approximately 325% of global GDP. Rising debt increases liquidity, and global debt has grown by some $70 Trillion (47%) in just the past decade as central banks, through quantitative easing initiatives, facilitated a form of “living beyond our means.”
So . . . . as US and global economies have benefitted from, and become increasingly reliant upon, easy money what happens to asset prices if / when interest rates increase substantially and / or that liquidity flow is otherwise reversed? My guess is nothing good, reflective of this broader perspective highlighting liquidity as the single most important determinant of asset prices:
” Earnings don’t move the overall market; it’s the Federal Reserve Board . . . . Focus on the central banks and focus on the movement of liquidity . . . Most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.”
– Stan Druckenmiller – billionaire hedge fund manager
Quantitative tightening, or central banks selling sovereign debt acquired in the quantitative easing of the past several years, is just now beginning. This increases the supply of government debt needing to be financed (by investors), which lowers the price of those bonds, which means higher interest rates. Further expanding the supply of bonds is what appears to be the dawn of $1 Trillion-plus yearly Federal budget deficits.
Part of the aforementioned paradigm shift causing the sudden increase in rates is likely attributable to the realization that we don’t know how the reversal of quantitative easing will play out given the unprecedented nature of the overarching global monetary experiment. Markets which do not embrace uncertainty generally, may well take umbrage with a fundamental uncertainty of this magnitude; that financial markets have not yet rebelled may be a function of the aforementioned strong – and ostensibly strengthening – economic backdrop.
Behavioral Finance Issues
A case for higher stock prices 6 and 12 months from now is easily made as the current readjustment runs its course. That process, however, may take some time as nervous investors sell into price recovery, thereby thwarting the recovery. Of the five corrections of 10% or more since the financial crisis ended in 2009, a new high was hit no earlier than 157 days after the old one.
Two common and costly behavioral biases impacting investor psychology are framing (referencing declines from a high water mark) and recency bias (tending to believe recent events will last forever). While the stock market may have corrected by approximately 10% in just over a week, it remains up some 19% over the past 12 months.
Keeping emotions in check can help when it comes to making investment decisions. Yet that’s often easier said than done due to a human neurological connection: the same part of our brain that regulates our emotions — the amygdala — is also used when we make decisions. Because of that, it’s very easy for emotions to take over, especially in stressful situations. The 24-hour financial news channels, the Internet, social media and other sources of sensory overload can also wear us down and lead to rash, emotional and sub-optimal decision-making. The media has its own agenda which often fosters fear and anxiety. Your agenda should be sticking with a plan and investment time horizon aligned to your objectives, featuring the right globally diversified asset allocation, an appropriate risk tolerance, and ample liquidity. This best equips you to weather inevitable market volatility and benefit from exposure to a historically superior asset class.
Even if the current sell-off were to become protracted, it may well not spell the end of the bull market. In fact, history suggests the final 25% of a bull run is where most of the gains happen (just as the final 25% of a bear market is where most of the carnage transpires). Some investors continue to look for an eventual “melt up” in stock prices as they balance the opportunity cost of missing out on late cycle stock market returns against risks associated with participating in the inevitable stock market correction(s). Such a rally could still happen.
Investors should be prepared for the possibility that excess global liquidity may have “pulled forward” future returns to some extent, or that the next, say, 7 – 10 year bond and stock market returns may well be muted as a result of current valuations and longer-term fundamentals. Takeaways from that:
- Lower valuations or a sideways market for an extended period should be welcomed by younger investors and those contributing regularly (systematically) as they are accumulating on the cheap;
- Investors young and old should understand that old-fashioned savings is more important than market performance in their accumulation objective;
- Investors in the “retirement red zone” (5 years before and after retirement) are particularly vulnerable to returns over this pivotal period. As wealth approaches its zenith, investment performance impacts both accumulation and sustainable withdrawal rates in an amplified, if not immediately apparent, way.
Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing. The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without further notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results