I see a lot of articles being written on SA that give advice about the current market status without explaining the entirety of why the market is "misbehaving".
In hindsight the easy money era from late 2008-2015 was the over-arching stimulus for the capital appreciation within the stock market. In a focused-scope view, the current volatility is most-easily explained by the reversal of this course. Without this accommodation, stock prices are no longer free to run a relentless march upwards while disregarding global shocks. More on that later.
The markets, then, are now un-weaned from the money glut, and free to focus on macro-economic stimuli, historical valuation metrics, and earnings. It is these considerations that are driving the volatility in the market. Risk is of paramount importance; the Vix is alive again.
To try and shed some light with my two cents, I thought it would be apropos to write a brief summary of pressures on the equities market with a multi-asset class view. In essence, I want to explain why the stock markets are so volatile by looking first at the equity market and the effect of monetary policy in part 1, and in part 2 taking a look at the commodities, currencies, and global growth prospects.
The Effect of Monetary Policy
The current economic landscape has changed, and this change is evident across asset classes. The great catalyst for equities in the post-Great Recession era, quantitative easing (QE), is now being slowly undone by the tightening monetary policy of the Federal Reserve.
Equities have flourished in the zero interest rate, $4 trillion liquidity injection environment from 2008-2014. After the booming rise and subsequent crash of the housing market in the early 2000s, equities became the asset-class that only-went-up, thanks to the accommodative policy of the Fed.
Start-ups in high-barrier-to-entry industries saw their stock price shoot ever higher as they reported bigger losses in revenue along with excuses that seemed ever-easier to accept. Investing reached a fevered pitch in 2015; sentiment far-outpaced earnings for capital appreciation.
QE's effect on the markets is transparent. After the crash, it was the catalyst for investment.
It seems pretty clear that the S&P 500 in 2009-2014 could effectively be referred to as "The QE S&P".
To take a closer look, let's breakdown these three time periods: QE (Nov. 25, 2008 - Oct. 29, 2014), Interim (Oct. 29, 2014 - Dec. 16, 2015), and Tightening (Dec. 16, 2015 - Current).
It is clear to see that after the Great Recession, the monetary policy of the Fed has been the map to investment returns. The environment of stimulus has led to massive and sustained capital appreciation for the S&P 500: a sustained 6 year average of 20% in that time frame. This sustained growth was enjoyed thanks to the zero interest rate policy of the Fed (which has suppressed bond yields). I will talk more about bonds in part 2.
In the interim period between the end of QE and the first rate hike in December 2015, we saw the theme of heightened volatility and an increased awareness of global pressures. The commodity rout, which saw crude oil prices sliding down a hill of oversupply, the Greek debt crisis (still ongoing, but no longer in the spotlight), and concerns over China's slowdown started to have an impact on U.S. stock markets which has long been seemingly inured to these considerations.
How global pressures weigh upon the minds of investors has come to the forefront of forecasting stock market returns. The "fear index", the Vix, is a good snapshot of investor sentiment at a glance. Let us look at where the Vix has been in these three time frames and what it tells us going forward.
Volatility is a rather opaque index. It is tracked by the difference (or spread) between calls and puts, or simply the bets of the future movement of the S&P 500. A rising Vix signals a bearish sentiment for investors, as short positions rise. While not a perfect indicator of future returns, spikes in the Vix generally signal bad times ahead for the market.
Please note this chart is as of Jan 5, 2015. The VIX and the S&P 500 are strongly-correlated inversely, as the CBOE admits about an 80% correlation on their website.
Here are the Vix levels for the three monetary policy environments so far (QE, Interim, Tightening), along with their simple moving averages (sma, 50 days):
As you can see here, we have a declining Vix, as well as a long-term decrease in the simple moving average (the average closing price over 50 days). Markets were certainly on edge in the early days, spiking on a "flash crash" in 2010 and when the U.S. sovereign debt rating was lowered from AAA to AA+ in 2011. The long-term trend downwards was still evident in the QE period.
The interim period between QE and tightening shows a lazy drift for much of the early period, highlighted by occasional upswings around global events and rate-hike expectations. We see a rising trend starting in the middle of the year, however, and it is important to note that even thought the Vix calmed down after the July/August China scares and "Black Monday", it remained elevated in comparison to the QE period. By the end of this period, the sma is sitting 20% higher than at the end of QE.
Today the Vix remains elevated, there is a clear uptrend to the sma. In fact, though it has only been 5 weeks since we saw the Fed raise rates off the zero-bound, the sma has shot up over 19.50: another 17% increase from the already-raised sma taken from the day before the rate hike.
The stage is thus set for the drama to unfold in 2016. We are due for a correction, and it is my belief we are staring down the barrel of one for 2016. To really get the pulse on the markets, however, one has to look at the most important thing: earnings.
I am a firm believer that the long-term value of a stock must be underpinned by earnings. It is easy to get lost in technical analysis, historical appreciation, and corporate ambition. The problem is that the first two of these are backward-looking, and too often the third looks too far forward. All things considered, I want my investments to show strong historical earnings as well as a plan for growing earnings in the future.
If a stock market is appreciating, it should be due to core earnings growth and rising prospects. Coming out of the recession, we certainly experience huge corporate earnings growth, as measure in eps (earnings per share) for the S&P 500:
This chart is current (Q4 2007-Q3 2015). We see a huge drop in 2008, but also a huge rebound starting Q1 of 2009 as the Fed's QE began. See where that decline begins? That happens to be Q3 of 2014...which happens to be when QE ended...
Corporations had to start tightening their belts. Shareholder sentiment became secondary, as the real threat of a rising interest rate environment came to the forefront. To corporations this means it will be more expensive to refinance debt, and more credit will be more difficult to obtain. More on debt will be discussed in part two, but keep this fact in mind.
To get back to the main point, we certainly did see earnings per share growth throughout QE, giving justification to rising stock prices. Make no mistake, I'm not here to stand on a soapbox and launch a diatribe about how the stock market should not have risen in response to QE, merely to point out how strongly it affected the stock market, and how much impact tightening can conversely have.
I only take issue with one thing about eps since 2009: a majority of it isn't even due to core business growth but to stock buybacks. In the face of a weaker-than-reported economy, corporations could theoretically use easy credit to borrow money and buyback stock to game the system. This would lessen dividends to be paid to outstanding shares, but more importantly this would lessen dilution in the share float, leading to more earnings per share simply as there were less shares and the same amount of earnings. This would be a neat trick in the short-term to show earnings growth, but would lead to higher debt in the long term and less spending on research and development, as well as improving core businesses for long-term growth.
Just how much have buyback levels rose?
We were right back at 2007 levels in 2014, and 2015 was even more so. It pains me to use CBS News as a source, but this article gives us a number:
"Since 2009, when the recession ended, buybacks have accounted for 21 percent of the buildup in market capitalization for the S&P 500."
It is certainly something to think about with the S&P 500 p/e currently 27% above its historical mean...
If you liked the article (and possibly are very cynical about the market) Please give me a follow. Part 2, which will be released in a day or two, will look at a global view of commodities, currencies, and debt, and give some actionable advice for investing.
I suppose I didn't really talk about why the market meltdown doesn't matter...Stay tuned in Part 2 for that as well.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.