Whew, what a week!
On Friday the 2nd, an economic report came out stating that wages were increasing. That surely was good news for the market… or was it?
Higher wages mean the economy is reaching full employment, which means that in order to hire an employee, you need to lure him away from his current job at a higher salary. This translates into higher expenses for employers, and less profits. If the employer wants to make up for the shortfall, he needs to raise prices. And that, my friends, is called inflation. Inf-what? of course, we haven't had any inflation for a long time, and all of the sudden, it hits us: It was there, all along, never left, only waiting patiently in the sidelines.
Interest rates rule! and this is not the former bond trader in me speaking, it's a market fact.
Couple this with jump in interest rates, and you have a Molotov cocktail. Why are interest rates so important? Interest rates rule! and this is not the former bond trader in me speaking, this is a market fact. Interest rates determine the amount of money you will get relatively risk-free, if they are very low, they encourage investors to look for riskier assets in the stock markets. Interest rates are also used to discount cash flows, the higher the rate at which you discount future cash flows, the lower its present value.
Does this ring a bell? Bingo, that is how you assign a value to the stocks. So what we saw last week, was a reprising of assets using a new discount rate. But there is more, the wages report and the high interest rate unleashed a 30% increase in volatility in one day to be exact. The VIX went from 13 to 17 in one day. As for the markets, the dow dropped a diabolical 666 points to close at 25,520.96 But all this was child's play…
Fast forward to Monday, no upsetting news, no war, no terrorist attack, no credit market meltdown, just a regular February Monday. The market really took a swing, it moved 1,596.65 points from intra-day high to intra-day low, before closing at 24,345.75 effectively wiping out all of 2018's gains. What is interesting, is that there was very few buyers, and the stocks kept plunging as new technical levels were breached, and thousands of stop orders were being triggered. By then our good friend uncle VIX had shot to 37 points, more than doubling the previous day's close.
Tuesday was no better, as the market opened lower, and promptly lost 567 points before shooting up 764 points. All this within the first half hour of trading… so, what was uncle VIX doing all this time? Shot up to 50. Remember this was an index that remained under 10 for most of last year.
Long story short, the Dow moved over 1,000 points in two, and over 500 points in three out of the last seven sessions. Why?
For starters, the markets are normalizing after a decade of continuously rising. Interest rates are also normalizing after a decade of near-zero levels. Volatility has returned to the markets, and inflation is playing peek-a-boo.
An important factor was the short-volatility trade. Given that volatility was so low for such a long period of time, betting against it became a no-brainer. Some ETNs that track the inverse of the VIX (NASDAQ:XIV), and others that seriously leverage that inverse tracking were purchased by hordes of investors, many of which lacked understanding about what it was made of, how it traded, or how 8t was valued… as soon as the VIX shot up, the price of the XIV imploded, losing around 95% of its value, instantly.
Another important factor was leverage. With rates at almost zero, investors were leveraging their positions. And we all know what happens when the markets make a correction… they bring a wave of margin calls with them. Finally automatic stop orders set at specific technical levels, they tend to exacerbate downsides by creating a vacuum in which stocks are free to fall.
Is this the beginning of a new bear-market? Hardly, we may see further drops, but the fundamentals are strong, and that should pave the way for a longer winning streak. A 10% correction is healthy, helps purge things overpriced stocks and reset the markets a more realistic levels.