Wow – what a week in the market. So, what happened to the markets this past week? Although nobody has 100% understanding of all aspects of what we just experienced and are experiencing, we are going to take a stab at sharing some insights that will, at the very least, shed some light on these violent and volatile moves.
On Feb 1, 2018 the Atlanta Fed’s GDPNow model forecast for Real GDP Growth, projected 5.4% annualized growth in the first quarter of 2018. Link
This is good news, right? Let’s consider this and a few other things – we have good economic news in several areas:
Wages going up.
Lower unemployment (labor pool is tightening).
Income tax cut – leading to more cash in Americans’ pockets.
Possible national infrastructure program (bridges, roads, ….).
Corporate tax cuts (35% - down to 21%) resulting in higher wages and many giving bonuses already.
Many other positive and encouraging signs that things are improving.
Considering such encouraging factors, why is the market not roaring up – but rather, experiencing such volatility and violent downside swings recently?
We think the underlying issue is uncertainty leading to fear concerning just how high and how fast the FED will raise interest rates (monetary policy). I will try to explain this in some detail – yet keep in mind there are many moving parts involved and I’m sure in this short blog I’ll not be going into great detail in all areas. “Good news” for the moment (short term) is being perceived by the market as bad news. Rising interest rates put pressure on both stocks and bonds. As rates rise in the bond market – the inverse is true of the price of the bonds and stock investors see a tightening of interest rates as a move to cool (slow) corporate borrowing and ultimately adjust the valuation relative to the risk- free rate of investing (T-Bills). Investors will re-evaluate the risk premium associated with their stocks based on the higher rate of yield on the risk-free Treasure Bond and increased cost of borrowing money for expansion and other operations.
It could easily sound like I am saying rising interest rates are the problem – I am not saying that at all. Rather, the uncertainty of not knowing what the FED intends to do has created quite a bit of fear followed by extreme actions. The FED may very well manage their responsibilities well leading to what we call a “soft landing” – controlled and orderly growth while keeping inflation under control – this is what we all are looking for. Rising rates for the right reasons are fundamentally good and will serve their purpose – thus blessing all of us.
I want to attempt to explain the incredible volatility we saw this past week. The main driver was the massive increase in the VIX (volatility index). So, the question is why? For the past 8 to 10 years we have had largely stagnant wages and very low inflation and we have not had a correction of greater than 5% in more than a year. These conditions have led to a bit of a coiled spring in several financial products that we believe have greatly exaggerated the recent behavior in the market. Many of these products are relatively new and use algorithm-based platforms. Some of them are set up to buy and even use leverage when things are calm and the VIX is low – as the VIX moves up (which it did drastically this week) – they are forced to sell and de-lever. This “forced selling” is then followed by more program selling as technical analysis calls for it. We saw this play out this week – on Monday when for more then an hour the S&P 500 and the DJIA were bouncing off the 50-day moving average and finding support (indicating buy orders at that technical point). Something significant happened around 2:15 when the VIX spiked and the sellers were in full force as we broke through the support (50-day). Once through the 50-day – “forced selling” picked up as some of these financial products were facing real liquidity issues. Simultaneously, buys on the other side were drying up creating a downside vacuum effect. If leverage is involved as in many cases it was – it exasperates these moves and forces selling with no regard for fundamentals.
Investors are uncertain what the FED intends to do – this is always the market's enemy from a “risk premium” point of view as it relates to equity valuations relative to T-Bills and the ultimate motivator of rising rates – inflation.
Let us remind you that things are much different then they were in 2008 (financial crisis). Interest rates will go up as the economy grows – and this is good – not bad – as we are counting on the FED to do their job to help insure what we call a “soft landing”. Interest rates are on the rise for the right reasons – earnings are growing, wages are going up, people are being put to work, and corporate margins are expanding. As cooler heads prevail and the fear factor calms down – along with less uncertainty – we believe many equities and sectors of the stock market will have a very bright future in what is still a very low interest rate environment.
We saw some encouraging technical action in the market Friday the 9th as the S&P 500 moved down to the 200-day moving average not once, but twice during the session – finding support as the VIX dropped (very key) – leading to fresh buying only to close nicely up for the day. Although we don’t know where the market will go this coming week – Friday’s technical action was very encouraging and Corporate Fundamentals are very strong. That underlying value will eventually attract capital and we are working hard to make sure you benefit as our clients from this next real move up.
The S&P 500 did hit official correction territory Friday at the lows – more than 10% down from recent peak – keep in mind we believe this is a correction and not the beginning of a bear market. Historically rising rates for fundamentally right reasons has resulted in a rising equity market along with rising rates. History is not a guarantee for future performance, but is helpful in reading current conditions.
We hope you are able to find some peace in knowing that much of the selling has been technical in nature - “forced selling” – not fundamental – therefore it makes sense to realize we now can buy many companies at much lower prices. Our analysis leads us to believe that this will be a short- lived correction. At some point “good news” will be good news again. It will be helpful for the FED to give some thoughts concerning their expectations, thus calming the uncertainty which is at the root of this volatility.
We appreciate the trust you have placed in us at MFG Wealth Management, Inc. and enjoy the opportunity to serve you.
Authored by: Michael McCracken CFP®, ChFC The information presented above has been prepared for informational purposes only and the commentary represent the opinions of the author and are subject to change at any time due to market or economic conditions or other factors.