The last few trading days have been a wake-up call for investors who have previously enjoyed the warm embrace of a low-volatility, zero-correction stock market rally. With little notice, the Dow Jones Industrials Average fell a staggering 2,838 points from the intraday high on January 26 to the lows of February 6 (we’ll get to the flaw of using point drops later). The S&P 500 Index has come along for the ride and, like the Dow, has already undergone a full textbook correction in just a handful of trading days, stopping just a hair short of a 10% peak to trough decline as of this writing.
What happened and where do we go from here? While we will review the various clues leading up to the selloff, a caveat is necessary. We must differentiate between a fundamental change in the market and what we might call a byproduct of market exuberance. By digging into the charts and data points, we can certainly find some hints as to why the market topped and tumbled on 1/26 - we will include our findings in this letter. Nevertheless, it is of our mind that the latest market slide not the answer to a question of the market’s fate, but rather the question itself, asked for the first time in years. Decisions must be made in the months ahead, and our job has just begun. Let’s review.
Perhaps the best place to start applying context to the market decline is with valuations. The market’s “value” is subjective and perpetually debated; however, some basic metrics can aid the process of valuing stock markets by assessing the relationship between stock prices and corporate earnings.
A cyclically-adjusted modification of the Price to Earnings Ratio, called the CAPE or Shiller PE, helps smooth out readings and temper the impact of recent swings in earnings. Below is a chart of the Shiller PE Ratio, courtesy of Robert Shiller and multipl.com:
As you can see, at 32, the CAPE Ratio is at highs rivaled only by the bubble of the late 1990s. There are downsides to using the Shiller PE, most notably its extended time horizon and that it does little to adjust for a nascent earnings boom too green to be reflected in the metric’s denominator. However, it’s safe to say that US stocks are objectively /expensive/. And when stocks are expensive, it typically means that investors and traders are heavily relying on a mental model in order to rationalize their buy decisions, e.g., citing the “new economy” of the late 1990s or the Nifty Fifty, “can’t lose” meme of the 1960s. Today, it is our view that the markets are ignoring valuations not solely due to tax cuts and earnings growth. They have also hanged their hats on the idea that the Federal Reserve has pledged to remain behind the curve, not wishing to take the punch bowl away in the absence of sufficient inflation rates and in the presence of the government’s fresh venture into easy fiscal policy (Powell and Yellen’s predecessor, Ben Bernanke, pressed Washington for years to use fiscal policy instead of relying solely on monetary easing. For the Fed to reverse course right when they finally got their wish would be a fateful decision). The normal interplay between growth and interest rates is typically an “automatic stabilizer” for the economy and stock market. The Fed’s commitment to “low and slow” has effectively disengaged the governor on stock prices, contributing to the runaway market since the 2016 election.
All this has set the stage for 2018, in which inflation data and average hourly earnings have begun to tick consistently higher. Further, Trump’s tax cuts have pressured Corporations, already swimming in cash, to announce wage hikes as a quid pro quo for the GOP’s once in a generation gift. As a result, we have seen bond yields climb significantly this year. Here we see the 2-year yield’s gradual, then accelerated climb:
Once dormant, the bond market has reestablished its position as a key market indicator.
In a related corner of the financial markets, the CME Group has a useful tool to visualize trading in Federal Funds Futures, a way to bet on the Fed’s next moves. The chart below from the CME website converts futures prices into implied trader expectations for future Fed Funds rates:
Source: CME Group
Note the gray line, which traces the probability of a 1.75-2.00% rate after the June FOMC meeting (the current target range is 1.25-1.50%, with the next three meeting announcements scheduled for March 21, May 2, and June 13). In concert with Treasury yields, the perceived odds of two rate hikes by June has soared since September, while the odds of of only one rate hike by June (red line) plunged this year. If one had to pinpoint the A1 reason for the market’s course change, it would be safe to look at the related moves in inflation, bond yields and fed funds futures, all within the framework of high, unforgiving valuations.
We would be remiss if we didn’t mention one of the most interesting casualties of the abrupt end of the market status quo: products and strategies that bet on low volatility. A booming niche of the hedge fund industry has been CTAs, or Commodity Trading Advisors, that use futures contracts as their tool to develop opportunistic trading strategies. The record lull in market volatility has naturally led CTAs to VIX futures in droves. By shorting the VIX (the VIX is the CBOE’s Volatility Index, which tracks implied volatility of the S&P 500 using options prices), these hedge funds have found the latest “can’t lose” source of returns. And in typical fashion, these funds, emboldened in their strategy each month the market went by volatility-free, and facing increasing competition due to natural market forces, likely eschewed hedging in favor of outsized, category-leading absolute returns. To quantify these returns, we look at [Credit Suisse’s] VelocityShares Daily Inverse VIX Short-Term ETN (Ticker: XIV), which promises returns equivalent to a short-VIX trading strategy. From Morningstar:
That’s 81% and 187% in 2016 and 2017, respectively. Importantly, these massive gains came without the volatility (yes, we’re talking about the volatility of the volatility ETN) expected based on Modern Portfolio Theory. In 2017, which saw a 187% return on XIV, there was only one down month (August, -11.33%). This is a recipe for disaster, when traders do not have to withstand the bitter taste of price swings on the way to a triple-digit annual return.
Then came the reckoning (Screenshot courtesy of our Co-Founder and Investment Committee Member Kyle Webber, by way of CNBC):
This post-market collapse (XIV fell even further, down 90% plus, in post-market trading on February 5) led to Credit Suisse’s decision to halt trading and prepare for a full redemption of XIV effective February 20.* The freefall was precipitated by a spike in the underlying [VIX] Index itself over the past week:
Historically, a VIX over 40 indicates a high-fear market, while a VIX under 20 signals trader complacency. Unfortunately, the high readings of 2007-2009 and suppressed lows of recent years have called these rules of thumb into question. We view the VIX asymmetrically: it is of little use to us as a contrarian sell signal (complacency/low VIX), yet it remains reliable as a sign of extremes in market fear at levels above 40. This week, the market plunge and the collapse of XIV has sent the VIX to a high of 50 on Wednesday, a level not seen since the Chinese market crisis in August 2015. From the perspective of a brave investor looking to buy from weak hands, this type of reading helps make their case.
To review, we have determined that global risky assets are selling off as a response to the worrisome possibility that the status quo of inflation, interest rates, and the Fed are about to change. The exact timing of the correction was, in our view, either random or, as with a house of cards, too complex to predict. After all, as some notable bears would know best, “overvalued & overbought conditions” have been around for much of the past five years or so.
As asset allocators and not market timers, our job has only just begun. First, fear-driven markets lead to relief rallies, more often than not. To unload at “fire sale” prices is hardly an attractive proposition. Therefore, the coming months will bring two core decisions for Quartz Partners and all other tactical managers:
Is there an opportunity to increase cash? This is a question not only of if, but if so, when? The fundamentals of the economy and financial markets remain intact. While the Inflation and Interest Rate Pillars** are the source of anxiety, both are attractive on an absolute value, as related to the others, most notable Earnings and Economic Growth. Until there are more fundamental signs of a market breakdown, we aim to use cash in a more targeted fashion, i.e., allocations of significantly less than 100%.
What is the optimal long portfolio for this environment? For as long as the fundamental picture remains sound, this is perhaps the timeliest question. As an illustrative analogy, we turn to the volatile market top and subsequent bear market of 2000-2002. The table below from Portfolio Visualizer shows annual returns by stock style from 1999-2002. What stands out is not only the horrendous returns of the previous market darlings, the tech-heavy Large Growth style, but also the strong /positive/ returns of small value from 2000-2001, led by the style’s overweight allocation to Financials and Real Estate.
Source: Portfolio Visualizer
The particular sectors that drove the performance differential is not important - each market cycle has its own winners and losers. The upshot is that while cash may be king during volatile market periods, there are also areas that should benefit from the sea change. Whether it is small value again, or commodities, or a particular global region, there will always be opportunities for strong relative performance. To identify and capitalize on these opportunities will be one of our key objectives in 2018. We encourage a consideration of whether client portfolios have been provided this type of flexibility, or at the very least, whether the focus of their current strategy may be tacking on avoidable market risk.
We close by reviewing three frequent "sins" that are commonly seen during rapid market corrections. Investors are urged to avoid falling into these emotional traps and aiming for a more virtuous perspective:
Focusing on points rather than percentages: This week, the media has a laser focus on citing “the largest point drop in the Dow’s history.” While there is rarely a positive spin on the largest point drop in history, we offer up a proper perspective and encourage a focus on percentage gains and losses. If anything, viewing market drops in percentage terms gives proper deference to the Dow’s “508 point” decline on October 19, 1987.
Selling on fear: the worst time to sell is when fear is at its “climax”, a term which is hard to define but much easier to sense. Market outperformance is not reserved for those who sold to 100% cash on exactly March 9, 2000 or October 9, 2008. It is awarded to those who properly evaluate the longer-term changes in market and economic conditions and adjust accordingly. In other words, today is neither too late nor too early to react. There are many more forks in the road to come.
Ignoring warning signs: we have asserted that the fundamentals of financial markets and global economy did not break down last week. However, that is not to say that this latest selloff is not a harbinger of things to come. If the Fed does indeed turn hawkish leading up to and during the March meeting, or if inflation readings such as the Consumer Price Index and average hourly earnings pick up further steam, the high valuations of US stocks could put investors at risk of a 20% plus selloff, i.e., a technical bear market.
More to come.
Joseph Arena, CIO
Quartz Partners Investment Management
**We separate our market analysis into seven “Pillars”: Policy, Inflation, Interest Rates, Credit & Liquidity, Earnings, Economic Growth, and Market Dynamics (valuation, trends, market psychology). Over 55 data points are analyzed in order to determine the strength of each Pillar.
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This material contains opinions of the author or speaker, but not necessarily those of Quartz Partners, LLC. The opinions contained herein are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable but are not assured as to accuracy. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is not indicative of future results. No part of this material may be reproduced or referred to in any form, without express written permission of Quartz Partners, LLC.