The financial markets these days are highly leveraged, especially with the loose monetary policy of the last decade providing ample credit for one-sided risk-taking. Add in the fact that financial markets have become highly correlated, with computer-driven algos preprogrammed to do x if y occurs. And assets themselves having predetermined paths in Risk On versus Risk Off environments. Throw in a heavy dose of coordination also known as collusion in some circles, client front-running, crowd behavior, group think, and human psychology and you get what we experienced in the fourth quarter this year.
Bad News and Financial Markets
But remember the old idea of trees falling in the woods, and the question if nobody is around, do they make a sound? Well, bad news isn't really bad news unless somebody sells in financial markets. All the known bad news and negative catalysts existed before October 1st, 2018, but financial markets ignored them all for three quarters, while oil continued to put in new highs and tech stocks continued to multiple expand into the stratosphere.
The trade war with China started 2018 in negative terms and ratcheted up every month with very little effect on financial markets besides an occasional after-hours futures selling period on a negative Trump tweet about tariffs that was soon bought up the next morning or sooner at the European open. The Fed continued to raise rates, talk hawkish and guide to more rate hikes. The midterm elections were never going to be good for the status quo of a Republican majority in both the Senate and House of Representatives with Trump's low approval ratings and multiple controversies surrounding his presidency. The economic data all pointed to a softening in global growth from Europe to China and the rest of emerging markets, and it was obvious to all that the trade war with China was only making things worse. All these factors were known, clearly visible, and with financial markets being forward-looking instruments, highly negative for all Risk-On asset classes. However, it sure didn't stop investors from basically buying everything that wasn't nailed down. Remember oil at $77 a barrel, Facebook (FB) at $220 a share and Apple (AAPL) at $230 a share?
Thus, bad news isn't really bad news for financial markets unless the big players start the avalanche of selling that then permeates the financial markets in the group participation of selling that follows suit. It is just how the game is played on Wall Street with everybody buying and selling together in a coordinated manner. Financial markets are as one-sided as they have ever been throughout the history of markets. There are a lot of reasons for this in financial markets evolving through increased technology, global participation, computer modeling and algo programs, access to fund flows by everyone, interconnectedness of financial markets including institutions and participants, and improved real-time communication that can see the future before the day's trading occurs in financial markets by reading order flows. One could even say that there is no way to have any "Chinese Wall" separation from an information flow standpoint whatsoever these days. Once a big player is going to sell, the news spreads fast in financial markets through many communication channels. Moreover, that genie is out of the bottle and probably never returning without major changes from a structural and regulatory standpoint.
The Fourth-Quarter Explanation
Given this backdrop, here is what happened in financial markets during this fourth quarter. Over the last 10 years, it is not uncommon for financial markets to have very strong fourth quarters, even if they start out very weak from an Ebola-inspired market selloff, a China slowdown contagion scare, or a pre-election go-to-cash selloff. All these selloffs in the fourth quarter provide nice entry points for buyers and investors to push markets much higher into the year-end close. Well, we started October with the selling; it was apparent the moment the third quarter ended and the fourth quarter began that something was different in the price action of financial markets.
The VIX Market
You could experience this difference in the VIX markets. It was obvious that somebody big was selling, and everyone knew it after a couple of days as the word spread. There was no new news, like a major terrorist event, Enron collapse or a major geopolitical or natural disaster that would suddenly change things. All the known catalysts mentioned at the beginning of this article were known by all investors for the entire year. The first part of the selling was just positioning before the midterm elections - an event that likely could be negative for the status quo. But said investors wanted to lock in the third quarter before unwinding ahead of the midterm election. So once October 1st beckoned in the fourth quarter, it was time to unwind some positions. This is not unusual, as we saw this before the Brexit vote and the last US Presidential election in 2016. There was a slight bounce after the election, only to have major selling into that rally. The "why" is the question here.
Short Side versus Long Side
It isn't very complicated - there was just too much to overcome to have a strong Santa Claus rally of a fourth quarter this year to the upside. And like I always say, when in doubt, follow the money. Remember, in order to push markets higher, a long investor had to overcome a heightened trade war with China, rate hikes, impeachment talk from the Democrats, slowing global growth acerbated by the trade war, already extended positioning in many asset classes - from bonds and equities to the oil markets - and the contagion that plays out when credit markets and leverage start to unwind.
In short, the play was to sell previously extended positions in overcrowded trades and asset classes, and at the same time buy derivatives and open new short and opposite trades in the direction that the big players were unwinding positions. So, there was a Santa Claus rally this fourth quarter, it was just from the short side this year. You better believe a lot of money was made this fourth quarter in the financial markets. It wasn't an accident there was no bid on many days in the fourth quarter of the markets. And it wasn't a coincidence that oil and equities traded together in lockstep in the fourth quarter when looking at the big picture. Of course, oil was oversold at $45 a barrel, but it was going lower because the same institutions that were selling equities were selling oil markets - it is the same trade. And you can bet that the capital unwinding from equities was moving into bonds. Markets are so correlated these days that once the VIX goes above 20 and stays there for an extended period, one can just buy puts below the market, because that's where the markets are headed.
Don't Buy the Dip This Time
And sure, investors who were unwinding big positions lost money on those positions in the fourth quarter, but this was mitigated by the large amounts of money made through derivatives and shorts on the very markets and positions that were being unwound. If you're a large investor and you know other large institutional investors and you are selling, and you know that your selling will move the markets, then you are in essence front-running yourself. The moral of the story is size usually provides an advantage in financial markets. You and everyone else know not to buy the dip this fourth quarter because communication of this sort is conveyed implicitly and explicitly from an institutional standpoint. For retail investors, watch the VIX for your clue - what level is it hovering at? Is it above 17, is it routinely moving and staying above 20, multiple spikes above 23? These are signs of the underlying information spreading across financial markets.
Short-Covering Rally and The New Year
And for confirmation that a lot of money was made to the short side during the fourth quarter, just look at the large recovery in oil and equities the last week of the year, as some positioning was closed out at year end and continued heavily into the start of the new year. Yes, there were buyers, but where were these buyers for most of the fourth quarter? They walked away from markets from the long side if we are talking about oil and equities during the fourth quarter. And you better believe the same people who were shorting the market were buying up their positions and opening new positions at the start of 2019.
Just like the end of the third quarter and the start of the fourth quarter was an important driver of positioning by market participants, likewise the end of the fourth quarter 2018 and the start of the first quarter 2019 was an important driver of capital fund flows and market positioning. In summary, pay attention to the VIX for clues as to a change in market positioning, especially when it is time to change direction in a major way. If the VIX is routinely being sold down below the 13 level for most of the year, and then it all the sudden jumps above 17, quickly moves above 20, and spikes above 24 and continues to stay around the 21-22 level for an extended period of time, you know that this represents a regime change or paradigm shift in the underlying fund flows of the financial markets.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.