The following memo was sent on Friday evening, February 9th at the end of last week's market action and volatility to BCM's current clients.
On Monday, we wrote to you about the current state of the stock markets, how we have come off of a period of unprecedented low volatility, and tried to provide some historical context to the frequency and severity of stock market declines. A lot has happened since Monday, and we thought it would be beneficial to share our current thoughts and perspective.
As of last night’s close (2/8/18), the major U.S. Stock indices officially entered a correction as they have fallen over 10% from their all-time highs. As the chart below shows, the true anomaly was the parabolic rise in the stock markets during the month of January. In January, the S&P 500 rose ~5.72% which is much higher than the long term average monthly gain of 0.78%1. To put this year’s price movement in perspective, if Rip Van Winkle were to invest in the S&P 500 and go to sleep on January 1, if he woke up today he would find that his portfolio was only down 1.84%. If he went to sleep on Thanksgiving, he’d be flat. The surge above this upward channel clearly shows the S&P 500 getting ahead of itself and in the second chart one can see the same phenomenon in the MSCI All Country World Index.
Source: Bloomberg, Beaumont Capital Management (BCM), as of 2/9/2018
This correction seems to have started from a rather modest 60 basis point rise in interest rates as illustrated by the 10-year U.S. Government Bond Yield chart. The spark of the sell-off was a seasonally adjusted wage report which showed a sudden increase in wages paid which the markets interpreted as very inflationary for the future. We do note that inflation has yet to show up in any meaningful way in the Consumer Price or the Producer Price Indices. However, reality versus expectations is often won by expectations. This fear of future inflation and rising bond yields caused not only a bond market selloff but also started the stock market decline.
Source: Bloomberg, Beaumont Capital Management (BCM), as of 2/9/2018
The sudden selloff caused a spike in market volatility as measured by the CBOE Volatility Index (VIX) shown below. We noted on Monday that the index spent much of 2017 at about half of its historical range. The volatility of the market spiked from 15 to 50 in three trading sessions. The good news is that the volatility level is substantially less than Monday and appears to be in a downward trend. We shall see.
Source: Bloomberg, Beaumont Capital Management (BCM), as of 2/9/2018
This surge in volatility created a secondary selling effect in low volatility investments. During 2017, when the VIX was at its historic lows, many investors poured trillions of dollars into low-volatility products designed to be held for hours rather than short, let alone long-term investment periods. When volatility spiked, many of
these investments were literally wiped out. At least one exchange traded note issued by Credit Suisse has been closed and several others are showing their values close to zero. The chart below shows that during this week, almost $3.5 trillion of value has been wiped out, mostly from these low volatility Exchange Traded products (ETP). The unwinding of these derivative instruments has certainly contributed to the unusually high volatility experience this week. It also helps illustrate why BCM only uses long-only ETFs and why we avoid ETFs that actively employ margin, leverage, inverse, options and other complicating factors.
Source: WSJ Daily Shot, as of 2/9/2018
The drama in Washington certainly did not help calm nerves. All week we had yet another Government shut-down threat and our Government actually did get closed last night. This morning both the House and Senate passed a 6-week spending bill to tide us over until a 2-year package is negotiated between the chambers.
Another unusual factor found in this market decline is the steep slope. In the chart below, the slope of this correction is much steeper than the average correction or bear market. We attribute much of this to the unwinding of the volatility products. What is important is that what typically takes 4 or 5 weeks happened in 4 or 5 days. We also note that if this is a correction, then the light blue trend line should kick in shortly.
Source: WSJ Daily Shot, as of 2/9/2018
All in all, despite all the sensational headlines spouted by CNBC and the rest of the financial press, the fundamentals supporting current stock market prices are quite strong. Revenues and earnings are growing at a robust pace. So far this quarter, of the companies that have reported, 76% have had positive revenue surprises and 81% have had positive earnings surprises. These are not indicative of an unhealthy market!
Source: Yardeni Research, Inc., as of 2/8/18
In addition, if we look at the Leading Economic Indicators of the 35 Organization for Economic Co-operation and Development (OECD) countries, we note that the level is healthy and accelerating.
Source: Evercore ISI, as of 2/8/18
In any event, after more intense volatility today, we were pleased to see the markets recover ~1.5% into the close. Regardless of next week’s action, our rules based processes are poised to act if, and only if, necessary. As we mentioned on Monday, we will not anticipate nor will we panic. We do, however, stand ready to sell if the decline continues. Until then, we will do our best to keep you informed.
Sincerely,
David M. Haviland I Managing Partner & Portfolio Manager
salessupport@investBCM.com I Phone 888.777.0535