I'm never sure whether it's worth pointing out things that are intuitive, but generally speaking, I find that what's intuitive to some readers isn't always intuitive to others, so the deciding factor for me when it comes to taking the time to put digital pen to digital paper is whether or not the intuitive dynamic in question is important. So because you're reading this, it means I've decided this is important. Hopefully, you'll agree.
Bloomberg was out late this week with what they're calling "Six Market Charts to Watch for Hints on Next Year's Big Moves." One of those charts shows the daily change in big-cap tech (QQQ), the Energy Select Sector SPDR ETF (XLE), and the KBW bank index (KBE). The point of the chart is to show that there were only two days in 2017 where all three declined by 1% or more. I made my own version of that chart. Here it is:
You should instantly recognize those two days (August 10 and August 17). August 10 represents the aftermath of Donald Trump's "fire and fury" comments on North Korea, and August 17 is the day the market got spooked by a rumor that Gary Cohn was set to resign.
Incidentally, I made a big deal out of that Cohn rumor (see here), and a lot of readers seemed to think that was unjustified considering he didn't actually resign. Well, if you go back and look at the charts for 2017, that day sticks out like a sore thumb on almost any daily chart you care to consult. The reason why that day was so important for markets was not so much because Cohn was reportedly displeased with the administration's handling of the Charlottesville incident (and by the way, Cohn himself would later confirm to the Financial Times that he was indeed displeased, so that was not mere speculation on the part of the media), but rather because Cohn was the linchpin for the tax cut push. Losing him would have thrown the tax effort even further off track than it already was at the time.
Ok, but that's not the point. The point here is precisely what Bloomberg says it is in the piece linked here at the outset. Namely this:
The secret to U.S. stocks' success in 2017 was rotation. The above chart shows that the KBW Bank Index, QQQ (the ETF that tracks the Nasdaq 100 index) and the Energy Select Sector SPDR fund have only seen two sessions in which all declined by 1 percent - compared to 14 such instances in 2016 and 20 in 2015.
This dynamic has helped keep implied volatility at ultra-low levels throughout the year.
Note that last bit. The VIX was 10 points below its historic average in 2017 and according to JPMorgan's Marko Kolanovic (who is the authority on these matters) roughly one-third of that is attributable to a decline of stock correlations. Recall this excerpt from Kolanovic's year-ahead outlook:
Perhaps the best example of the impact of correlation on reducing S&P 500 volatility was the market move on Nov. 29, when financials and technology stocks moved ~4% relative to each other leaving the S&P 500 index price unchanged (~5 sigma move).
That of course refers to the day when the factor rotation from momentum to value (visualized in the chart below) began.
The correlation point is critical for volatility, and it's been echoed in virtually every piece on the low vol. regime written in 2017. Here's Barclays for instance (from its 2018 volatility outlook):
Figure 7 plots the intra-index correlation (i.e., the average stock correlation between stocks in the S&P 500 index) and we see that it has dropped significantly this year. The same chart also plots the average inter-sector correlation (i.e., the correlation between the 10 sector indices) and the average intra-sector correlation (i.e., the weighted average of the correlation of stocks within each sector).
As the bank goes on to emphasize, this is a critical factor for index volatility. In other words, it goes a long way toward explaining this:
Importantly, this is not a phenomenon that's confined to the U.S. Here's a snapshot of inter-sector correlation globally:
And here's a related chart from SocGen which illustrates a similar dynamic strictly in the European context:
Now, recall that earlier this month, the VStoxx hit an all-time intraday low:
OK, so what can change this? Well, to quote Bloomberg again, investors should "watch to see whether an external shock or event risk is strong enough to overwhelm this year's bullish narratives all at once." Here's how I phrased it in a short (and highly amusing) post over at Heisenberg Report on Friday morning:
The question, then, is this: what kind of exogenous shock would it take to derail every narrative (in this case "every" means energy, financials, and tech, but you could also sub in HY, value, and growth - or whatever) simultaneously?
The easy answer there is an uptick in inflation that triggers a policy shock in the form of aggressively hawkish central bank guidance. In that scenario, it's likely that the bond tantrum which would almost invariably ensue would overwhelm any effort to pick "winners" from higher rates. But in the absence of that, you can look at the two episodes illustrated in the first chart shown above for evidence of what has the potential to trigger an across-the-board rout.
The evidence there is clear. The only other instance in which we very nearly got a 1% move lower in QQQ, XLE, and the BKX on the same day was May 17. That would be the day when the James Comey drama came calling.
So the bottom line is that all three times in 2017 when financials, energy, and big-cap tech sold off together were related to politics. That's not an attempt to make a political statement. It just is what it is. You can say the market overreacted if you like, but you can't dispute the numbers.
Ultimately, that just reinforces the Heisenberg raison d'être: Try as you might, you can't disentangle geopolitics and markets.
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.