Quarterly Market Overview 4.5.18
With the rapid dissemination of information in the Internet Age, a quarterly commentary can seem outdated, but we strive to provide perspective on unfolding events as well as insights into our portfolio positioning.
Recapping the first three months of the year:
- 2018 was greeted with a flurry of positive growth revisions following the passage of US tax reform. Combined with a strong Q4 earnings season - profits rose ~14% on a year-over-year basis - the S&P 500 marched to an all-time high on 1/26/18. Then fears emerged, technical selling programs were triggered, and a -10% correction ensued. As a side note, compared to peak levels in January, forward P/E valuations dropped ~12% in early Q2 before rebounding a bit.
- Most importantly, the volatility regime changed in Q1, and although this was widely anticipated by the consensus - indeed we spoke of this last quarter - the reality of increased price fluctuations is always unsettling. Fundamental factors prompted the correction, as is usually the case, but then technical factors took over. Specifically, the forced unwind of nearly $5 billion in crowded short-volatility ETPs (exchange-traded products) caused a spike in the CBOE Volatility Index (the VIX) of 350% in early February. This had a rippling effect. A normal pull-back accelerated to the downside as thresholds were triggered, leading to selling by leveraged strategies, including trend-following CTAs and risk-parity funds according to JPMorgan analysis.
Volatility trading has a self-fulfilling nature to it, especially when positioning is extreme. With investors piling into short-vol strategies in 2017, volatility was pressured lower, but now that many short-vol funds have been liquidated, market volatility is normalizing at higher levels. We see this normalizing as a transition process. It might take time and a series of data points, for investors to fully adapt.
“The equity volatility market, in our opinion, is now in a position to provide a more balanced and healthy environment for trading. In the past few years, strategies like the [exchange-traded product] XIV were blindly selling risk for incommensurate sums of money. We liken it to playing the lethal game of chance (Russian roulette) whereby each successful pull of the trigger can earn you a dollar, but the ultimate risk of death means the game is destined to end badly. Capstone believes the odds of making money in the equity volatility markets are now higher as the markets have eradicated a player who was a poor risk taker, but ultimately a player with a significant amount of money behind it, which made it difficult to compete against. But now, that dynamic has changed.” So said Paul Britton, founder and president of Capstone, a $2.9 billion global macro and volatility trading firm.
Breaking down the numbers: In 2017, and leading up to 1/26, the S&P 500 had an average daily price change of 0.3%, but the daily change averaged 1.1% during the 45 trading days thereafter. For the time being, we believe investors must accept the reality of higher price volatility, adapting expectations and/or positioning as needed.
Multiple factors are being referenced as causes for the market correction: higher interest rates, rising inflation, a shift in Fed Policy, the threat of global trade wars. We see all of these as legitimate to varying degrees, but concerns seem exaggerated as future outcomes remain unclear. Granted, uncertainty is a concern in and of itself. Most recently, protectionist rhetoric between the US and China has escalated. In fact, the tariffs announced by the US do not go into effect until May and China’s retaliatory tariffs do not yet have a start date. Trump’s new economic advisor, Larry Kudlow, has reassured markets that the back-and-forth is more of a public negotiating process. In a 4/2/18 interview on CBS, Ian Bremmer, global strategist and president of Eurasia Group, commented on the US-China trade situation as follows: “It’s significant... but we’re not in a trade war... it’s the Chinese taking it seriously. It’s not, I wouldn’t say this is seriously escalatory.” Things could change rather abruptly. It would not surprise us to see trade agreements improved in the near future. With the current Administration, there has certainly been a trend in which policy reality is less severe than policy rhetoric, but time will tell.
Markets climb a wall of anxieties, including extrapolated risks that are far from being realized. As we write this, two risk concerns stand out to us and both relate to momentum factors. First, US and global economic growth remains positive, but the pace of growth has decelerated, especially in Europe. We refer to this as the dreaded second derivative - the rate of change. For the US, the expected Q1 GDP growth pause falls in line with seasonal trends and economic growth is expected to accelerate over the balance of the year. However, for perspective, consider this: The March ISM Manufacturing report showed a sequential decline to 59.3 versus February (alarming to some strategists), but the growth pace actually accelerated during Q1. Readings above 50 signal expansion and crucial sub-indices like New Orders stand at 61.9. Sharing this information is a bit tedious, but we view recent ISM data as a microcosm of the broader environment. Admittedly, the deceleration rate is more pronounced in Europe, so that is concerning, but growth levels there are still positive. A second threat to momentum is the recent news with Facebook and the Information Technology complex in general. In short, security breaches at FB raise the risk of government regulation; revenue growth could slow if FB is restricted from selling its user data. For high-growth, high-valuation businesses, changes to future growth projections can lead to large price moves. FB dropped -20% from its recent high and the decline might dent the near-term leadership of the IT sector, but with IT bellwethers reporting Q1 earnings in a matter of weeks, the narrative could shift back to positive growth fundamentals. Perhaps more noteworthy has been the dispersion in recent performance between FB and its peers including Alphabet (NASDAQ:GOOG) and others. We see this performance discrimination based on fundamentals and company-specific events as a positive.
To summarize, Q1 marks a transition period that might take months to play out. Economic and corporate growth fundamentals remain firm, at least through the balance of 2018 and into early 2019. A number of risks are prominent, including elevated valuations for most asset classes, tighter-than-average credit spreads, disruptions across the consumer/retail industries due to the Amazon effect, and looming shifts in central bank policies. We are monitoring all such factors. In the meantime, rising volatility can provide opportunities when prices detach from fundamentals for temporary reasons.
In closing, we reference a comment from Brian Wesbury of First Trust from the firm’s Monday Morning Outlook on 3/26/18: ”Stock market volatility scares people. But, volatility itself isn’t necessarily bad. Only if there are fundamental economic problems, something that could cause a recession, would we think volatility itself is a warning sign. So, we watch the Four Pillars. These Pillars – monetary policy, tax policy, spending & regulatory policy, and trade policy – are the real threats to prosperity. Right now, these Pillars suggest that economic fundamentals remain sound... The bottom line: taxes, regulation and monetary policy are a plus for growth, spending and new tariffs are threats. Things aren't perfect, but, in no way do the fundamentals signal major economic problems ahead. The current volatility in markets is not a warning, it's just volatility.”
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.