I guess that it was simply too good to last. January’s market performance was nothing short of perfect. Stocks continued their upward trajectory and the atmosphere for investors was as placid as a serene summer pond. In stark contrast, February had more action than all of 2017 combined. At the heart of it all was the return of that multi-headed hydra of angst and turmoil called volatility.
The VIX, or Volatility Index, was at historic lows throughout most of 2017, with readings breaking below the 10 mark on several occasions. Equities and their owners acted as if they hadn’t a care in the world. But when we had our first whiff of corrective behavior, it was the proverbial “Katie, bar the door!” The VIX jumped to the mid-30’s level almost instantaneously. What happened to put rocket fuel into antacid sales this month?
As I’ve mentioned several times in these missives, we’ve been long overdue for a correction. According to Birinyi Associates, stocks have historically experienced downward moves of 5% every few months, with a 10% haircut at least annually on average. Corrections of 20% and beyond are less frequent, but still part of statistically “normal” market behavior.
In February, we had a pullback of nearly 10% that was both swift and merciless. Once the reversal began, it got ugly in a hurry. My feeling is that the train left the rails quickly because of margin leverage exposure leading to investors needing to sell stocks to raise cash. In addition, there were a couple synthetic products that basically vaporized because they were betting on volatility not returning in the short-term. Thankfully, we don’t use margin or reckless hedging products in any of our accounts.
At around the 10% level, fundamentals began to re-assert themselves and equities moved higher. By the end of the month, the major averages had recovered a decent portion of the pullback. We’re now a tad better than break-even for the year. While that doesn’t measure up to 2017 standards, I guess that if our portfolios are at par thus far in 2018 after enduring a correction, we should feel relieved. As we enter March, the salient questions become “Is the corrective phase finished? Will volatility return to last year’s low levels?” My hunch is no on both counts, at least in the near term.
Don’t get me wrong. I’m heartened by the fact that equities rebounded so nicely. I’m also a believer in the strong underpinning of fundamentals led by strong corporate earnings, solid balance sheets, consumer confidence, historically low interest rates, and tax reform. However, corrections often seem to have a mind of their own. There’s some historical math logic to my thinking that we’re not done yet. Without getting too technical, market troughs are a part of the major averages demonstrating reversions to the mean. If we flip a standard coin, we know that there’s a 50% percent chance that it will come up heads. If we did this ten times, you could get ten heads as an unusual result. If we did the experiment 10,000 times, though, the ratio would be far closer to 50-50. The larger the sample size, the more the results revert to the mean. Equities prices have done this forever, and today’s technology doesn’t negate old school math.
The other factor comes from a charting perspective. The rapid V-shaped bottom that we saw early last month is one that generally gets re-tested at some point in order to create what’s known as a “double bottom”. This classic technical pattern has been shown on many occasions to be a harbinger of better times to come. The market shakes out weak players a second time, and consolidates positions of strength. My guess is that a re-test will happen before the bull market gets new legs.
Along with these arithmetic truisms, there’s a wild card in our midst as well. New Federal Reserve Chairman Jay Powell had his first testimony before Congress on Tuesday, and he spooked Wall Street quite a bit. While his comments were generally benign, he did postulate that the economy “could be in danger of overheating”. Traders took this to mean that four 2018 interest rate hikes might be in the offing instead of three. The bond market reacted adversely, and took equities down with it. We’ll soon see if this is a “one off” event, or part of an underlying trend. I’m watching the levels on the ten year Treasury. The closer to a 3% yield that it gets, the worse it is for stocks. At 2.8% or below, it’s a more positive sign. Fixed income may actually lead the next equities move.
The true object lesson for February is that you cannot give in to panic at the first sign of a downturn. Corrections are totally normal. Stocks almost always go down faster than they go up. It’s painful watching portfolio values decline, and we haven’t honestly felt the roller coaster for a while. This doesn’t mean, though, that we deviate from our long-term objectives. Inflation remains low, and there appears to be little evidence of a recession any time soon. Yes, it looks like the Federal Reserve will be tightening in earnest, but equities have done well in these types of environments before. I’ll begin to get worried if I see corporate earnings wane.
In the meantime, while it’s difficult to enjoy the ride, just know that it’s normal market behavior. Reversion to the mean is a powerful concept that finally showed its colors again last month. Volatility is closer to 20 now instead of 10, so we’re probably not out of the nervousness woods yet. Hang in there, and don’t forget to breathe.
As always, I appreciate your trust and support. Please feel free to give me your thoughts. I look forward to talking with you soon.
The opinions expressed in this letter are those of William Schiffman and should not be construed as specific investment advice. All information is believed to be from reliable sources; however, no representation is made to its completeness or accuracy. All economic and performance information is historical and not indicative of future results. Diversification cannot assure a profit or guarantee against a loss. Indices are unmanaged and do not incur fees, one cannot directly invest in an index.