Why the stock market fell
We are living in a global financial asset bubble characterized by an increasing correlation between stocks, bonds, and nontraditional assets like real estate. The evidence for this bubble is most notably visible in long maturity government bond yields (US Treasury at 2.85%) and high cyclically adjusted price to earnings (CAPE) ratios for stocks (S&P 500 at 31.3%). We wrote last month that we expect this trend to continue in 2018, but identified three risks that could make the bubble pop including war, inflation and populism. Here we examine the event to determine if we need to change course.
The narrative of the past week is that inflation is on the rise due to a tightening labor market. Wages increased by 2.9% over the past year which is clearly good for the economy, but some believe this is a sign of runaway inflation that will cause the Fed to increase rates faster than previously expected. Low rates are one reason investors believe stock and bond prices are so high. This narrative is consistent with calls earlier this year that the 30 year bond bull market is over by well known investors like Bill Gross. Higher rates, all else equal, do justify a drop in stock prices.
However, a 20 basis point increase in the 10yr Treasury rate and small rise in inflation expectation are poor explinations for a 10% correction in the S&P 500. Note that stock investors were perfectly happy to buy while rates rose until the 10yr hit 2.6%. We have two far more plausible explanations. First, the S&P 500 simply went parabolic in January and we were simply too complacent (and focused on #Crypto) to see the correction coming. The second reason is the popping of the short volatility bubble.
There are many ways to short volatility with writing put options being the most obvious. However, this approach is too complicated for most retail investors. A much simpler way was to buy the now defunct ETF called $XIV or some similar product like $SVXY, $VMIN, $EXIV, $IVOP, $XXV, and $ZIV. Valuations on these products rose in a manner very similar to #Bitcoin and other cryptocurrencies through 2017 and are a major contributor to why the $VIX set an all time low last year. The parabolic rise in stocks coincided with a parabolic rise in the short volatility trade.
Further evidence that the short volatility bubble pop is largely responsible for the stock market falling on Monday is the disproportionate rise in VIX relative to the fall in stocks. Implied volatility in option prices rose by nearly 120%, the largest one day move in history! In contrast, the S&P 500 fell by just over 4%; which is a lot but not rare. Those shorting volatility were essentially squeezed out and forced to liquidate positions at extremely bad prices. Liquidity for put options has been scarce ever since.
What happens next
A consequence of the stock market correction is that many investors woke up to 50% gains over the past two years and much higher valuations. Peak S&P 500 price in January was 15% higher than the 200 day moving average total return. Market was clearly due for a correction. The time since the last correction (early 2016) is a contributor to why this one is so fast (and painful). Many forgot what losses felt like. Complacency has now been replaced by concern and the result will probably be continued pressure on stock prices. Too much paper gain still exists now that bonds offer significantly higher yields (Vanguard’s intermediate corporate bond ETF $VCIT yields 3.26%) than most dividends (S&P 500 yielding 1.87%). That said, bear markets (> 20% drops from peak) rarely occur outside of a recession.
Stock prices fall when selling pressure is greater than buying pressure. People are still driving the buy/sell decision (even if it is through their algos) so one needs to examine the narrative in order to hope to guess what happens next. There are currently two dominant competing narratives, one for each side of the trade:
- Sell Narrative – Inflation and interest rates rates are on the rise. This is going to cause a selloff in both stocks and bonds. Stocks are already down 10%, but valuations are still so high relative to history that I should still sell now.
- Buy Narrative – Finally an opportunity to buy cheap into the stock market. Experts have been calling for a rise in inflation for years and nothing happened. Buy the dip and hold for the long run.
Fear came fast and furious last week so it’s not surprising that the sell narrative won out. But investors will have a chance this weekend to review the facts and come to the table a bit more calmly next week.
Here are the facts regarding inflation drivers and interest rates:
- Wages did increase but the chart (shown earlier) shows a steadily rising trend, not an abrupt increase.
- BLS data on wages in notoriously volatile. We calculated the standard deviation of YoY wage increases by month and found that January is indeed the most volatile report of the year.
- The employment report indicates that wages grew the most (3.64% or 0.75% over the average) for those already making the most. The same group also showed a 0.75% drop in hours worked compared to last January. This may be an indication that bad weather surpassed hours worked in January, thus inflating wage growth. Interestingly, overtime hours in manufacturing are up substantially YoY, but not up at all relative to recent months.
- Oil and other commodity prices sold-off last week relieving cost pressure on businesses (See Bloomberg commodity index total return $IND below). The dollar only rose 1.3% over the past week, not nearly enough to explain the selloff in commodities which fell closer to 4%.
- The Yield curve steepened dramatically suggesting that near term inflation is less of a concern than longer term inflation, and that we are far from a recession.
Putting this all together, inflation does appear to be increasing, but not yet at a path that would be destabilizing to the market. Next months employment situation report probably won’t show another outsized increase in wages. Commodity prices are likely to increase as global economies continued their syncronized growth, but without some additional exogenous shock (ex. Government collapse in a major oil producing country) the pace will likely be steady and not alarming.
As we have wrote about over a year ago, the fall in interest rates and inflation over the past 30 years was driven by many long term trends. The most important of these is that global wealth has grown while economic growth has slowed. Lots of wealth chasing fewer good investments necessarily leads to lower return on investment. Investors still have to put their money somewhere irregardless of whether interest rates are at 10% or 2%, or Stocks have a CAPE of 15 or 35. We have argued that this trend will continue as long as global wealth continues to growth relative to investment opportunity.
This dynamic is most easily illustrated in the credit market. Increasing wealth, as measured by assets relative to income, has provided increasingly cheap credit since the 1980s. Demand for credit has not kept pace because as global growth has slowed (as it generally has since WWII) leaving fewer good investment opportunities. A business is only willing to borrow at 10% if they can invest it and make far more than 10%. Profit margins today are exceedingly low. The low hanging fruit has largely been picked. New technologies and other innovations may bring us out of this multi-decade trend, but it seems unlikely that the “complacent class” (plug for Tyler Cowen’s book @tylercowen) is going to become more productive without some huge catalyst (read War/populist uprising).
So we are not anticipating some abrupt end to low interest rates in 2018. It may take a few months, but the broader trend of lots-of-wealth chasing few financial assets is truly great. Interest rates continued to fall during the Growth in emerging economies like China through the 1990s and early 2000s. Innovations like the internet and smart phones have not reversed the long term trend of falling productivity. For interest rates to rise, something needs to break (read War/populist uprisings). Wealth won’t stay in cash as long as financial assets have positive yields and a longer term upward trend. Therefore, we expect fear today to be replaced by the practical problem of holding cash in an environment of moderately rising inflation. Bonds that are not inflation indexed are clearly not a good investment in this environment. Stocks, despite (and in part because of) the selloff, probably still are a good investment.
Tomorrow we will share our S&P 500 valuations projections based on various interest rate scenarios…stay tuned!
Feel free to share your own thoughts on the stock market selloff this week. There is no better compliment you can give us than your thoughtful criticism. You can reach us at firstname.lastname@example.org, or follow us on Twitter @intuitecon
Disclaimer: These are our personal views. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Our hope is that these observations will merely help you to more critically examine your own beliefs about finance and stimulate dialogue.