Please return to your seats. The market has turned on the seatbelt sign: what happened last week, and what do we look for next?
Two weeks ago, my friend’s daughter, Leah, asked me to help her select stocks for her high school economics class. To be honest, I was nervous to recommend anything as the markets had gone straight up for an extended period of time. I really felt we were well overdue for a pullback. As the markets sold off sharply last week, I was less concerned about my portfolio and more fearful that because of the state of the markets (and more so the stocks I picked), Leah would fail economics, and my buddy since kindergarten would never speak to me again.
Looking for a bad guy
I have been in capital markets intelligence for over 20 years. What I’ve learned in that time is that while people are far less interested in what’s going on with their stock when it’s moving higher, senior management really leans in when stocks don’t perform as expected. That’s when I’m asked: Mike, who is the bad guy?
The recent decline in the market started on February 2nd, as the January employment report sent interest rates higher. The Department of Labor reported that January’s hourly wage rose 2.9 percent. This marked the biggest year-over-year increase since the last recession ended in June 2009. The report sparked inflation fears and sent interest rates sharply higher, making some believe that the risk/reward between stocks and bonds had changed.
The selloff continued on February 5th, as the Dow gapped lower by over 800 points and then slipped to the largest intraday loss in history -1,600 in approximately 10 minutes. How does this happen? Who is the bad guy? Did the markets break?
While higher interest rates were the original bad guy, traders quickly turned to inverse volatility ETNs and ETFs to explain the velocity of the sell off.
Following market close on February 5th, the two largest anti VIX funds — the VelocityShares Daily Inverse VIX Futures Short Term exchange-traded note and the ProShares Short VIX Short-Term Futures exchange-traded fund — came into focus. Shorting volatility has been free money for investors in a market that has shown very little volatility. The market had seen a record 404 days without a 5 percent move lower. The VelocityShares ETN and the ProShares ETF each gained more than 180 percent last year. This performance obviously attracted fund inflows and the products swelled into the billions. This incredibly successful trade turned horribly wrong in a matter of hours as the 4 percent selloff in the S&P 500 sent the VIX higher by over 115 percent. The biggest anti-volatility funds lost over 90 percent of their value (roughly $3 billion) and forced Credit Suisse (the sponsor of the XIV ETN) to shutter the fund.
Barclays estimates that an additional $500 billion of assets are tied to funds that target a given level of volatility and as volatility rises, these funds decrease their leverage to equities. This type of strategy creates more of a mechanical type of selling vs. fundamental and certainly added to the velocity of the declines we saw last week.
The Herd Mentality
Passive funds have swelled over the last three years pushing Vanguard, BlackRock and State Street Global to the top of most public companies shareholder list. When investors pulled a record $23.9 billion from funds last week, many of these firms were forced to sell stock.
State Street Global S&P 500 Index (top 10 holdings)
Our proprietary relative performance score helped keep IROs ahead of the curve with its real-time look into trading showing senior management exactly how much of the company’s move was tied to broad-based market selling.
Before the market turned positive on February 9th, I noticed that many of our clients had institutional buyers picking up shares into weakness. My team informed clients that if we saw an end to the program selling we expected shares to rebound off the lows. Fortunately this thesis proved true as stocks rallied off the lows later in the day.
With the bad guys identified–rising interest rates, inflation, volatility funds and index selling– how do things settle out from here?
Three percent mark on the 10-year note
Traders remain focused on the bond market and the 10-year note. The yields on the U.S. 10-year Treasury note closed at 2.83 percent, significantly higher than the 2.41 percent at year-end 2017. Traders look at the 3 percent mark as the line in the sand and a spike above that level could trigger another downdraft in the markets. All eyes will be on the January Consumer Price Index when it is released February 14 for our next piece of inflation data. Traders are expecting the core rate (less food & energy) to rise 0.2 percent with the year-over-year expected to fall 0.1to 1.7 percent.
S&P 500 200-day moving average
Buyers stepped in February 9th after the market fell briefly below the 200-day moving average. This mark will be a key line of support if the bull market is able to resume.
While the possibility of a bear market remains low and much of the decline last week was tied to mechanical and index selling, we are likely to see much more volatile trading in the near term. So buckle up and keep your trays in the upright and locked position, because things are likely to remain bumpy in the near-term.
Mike Coffey is head of Business Development, Intelligence at Q4 and has over 20 years experience in the capital markets. Mike is a regular contributor to Q4 blog.
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