Cracks In The Foundation
The bull run in stocks we’ve seen after the Great Recession of 2008 has been nothing short of incredible. The Dow bottomed out in March of 2009, touching levels not seen for the previous 12 years. Since then, the Dow has more than tripled in value during a period of record low volatility. The amount of wealth created by the rally of the past eight years – many trillions of dollars – has been astonishing. So why should you expect the market to correct now?
Recent developments have revealed some of the “cracks” in the foundation of the equity market. The move lower in stocks though the end of January and beginning of February is marked by some very unusual characteristics that serve as warning signs of further downside. For one, the market sell off didn’t start because of fundamentals. By most measures, the economy is doing well. Economic data and corporate earnings have been strong. And yet, the market continues to sell off, posting massive losses.Is it just the market correcting itself after a massive run higher in 2017? Is it simply moving down to “sensible” levels that are more in line with valuations? Not likely.
A few key factors tell us that this move could be much more than a simple correction:
-There is no clear reason for the market to be selling off this aggressively
-The sell off hasn’t been contained to U.S. markets – global markets have seen some of their biggest sell offs in the past two years.
-There doesn’t seem to be a “buy the dip” mentality amongst investors in this market.
-Market volatility is hitting record-breaking highs
These should concern you, to put it mildly. Typically, there’s a clear culprit behind a massive sell off like the one we’ve seen over the past few weeks. Economic data, corporate earnings, or geopolitical tensions are often the cause of moves like this. But for the market to fall like this without any developments in these areas
makes this selloff unique, and points to underlying weakness in equity markets. The fact that this sell off isn’t contained to U.S. markets only is another red flag warning us of further downside. It’s rare to see U.S., Asian, and European equity markets sharing their worst week in years, but that’s exactly what happened in the first weeks of February. What’s also different in this market sell off is that the dip buyers have left the market.
Canaries In The Bubble Factory Does a shift away from the “buy the dip” mentality really spell further downside for the market? One of his most important traders at Goldman Sachs seems to think so… On Friday, February 9th, Brian Levine, head of global equity trading at Goldman, sent a note to clients on his thoughts and predictions on what the sell off means for stocks. In his note, he explains how this change in market mentality, among other factors, represents a major shift in market dynamics…. And that investors’ negative feelings alone could send the market into major correction territory. We’ll get into the details of his note further in this issue, but the last line sums up his viewpoint… “Longer term, I do believe this is a genuine regime change, one where you sell-the-rallies rather than buy-the-dips…” Does this sound like something someone would say if they thought this sell off would be short lived? Definitely not. When the most important equity trader at the most important bank in the world is calling out something like this, it’s worth paying attention to. One of his main arguments is the same as we talked about earlier: the unprecedented moves in the volatility market.
The CBOE Volatility Index, known as the VIX, has long been considered the best gauge of investor “fear” in the market at any given time. On February 5th, as the Dow fell more than 1,400 points, the VIX saw a historical rally. In a single day, the VIX rose over 102% – the biggest single day jump ever. Historically, when moves like this happen, it’s a precursor to bearish moves in stocks. The move you can see on the chart to the right broke a record for single largest one-day move in the VIX. The last time that happened was in 2007.
What happened next? The market continued to head higher for roughly seven months, before selling off over 50% from the end of 2007 to early 2009. These factors all lead to one conclusion: This sell off has all of the potential to turn into a much larger correction. How do I know this? The signs are all there. For one, the key 100-day moving average in the S&P 500 (a broader measure of the equity market than the Dow) was also breached on this selloff.
For the past few years, this support level has been key for the stock market. But the market fell below that support level on February 7th. With this key support failing, the technical picture of the stock market looks even worse. Another key indicator is that the market drop is approaching the important 200-day moving average… a level that has not been broken in nearly two years. A breach there would likely give added momentum to the sell off. But what about the non-technical drivers of the market? Shouldn’t a stronger economy support the stock market? Yes… and no.
New Fed Policy A Double-Edged Sword Although both the technical indicators in the stock markets and volatility markets point clearly to a potential correction… You may have trouble seeing how this could happen in such a “strong” economy.
Let’s take a closer look at the Goldman note mentioned earlier for more on this… The note calls out that while technicals may have been the trigger for the sell off, focusing only on charts keeps you from seeing the bigger picture. In reality, this sell off is about a lot more than simple technical levels being breached. As I mentioned earlier, low interest rates and global central bank policies have flooded the market with cheap money for years. What we’re seeing now is likely the effect of a shift in those policies: Interest rate hikes and the end of easy money are undercutting support for both the stock and bond markets. While interest rates have been slowly rising for the past several years, the Goldman note talks about the possibility of a “tipping point” moment for equity markets.
This simply means that further hikes in interest rates could result in a stock market correction. Is it a coincidence that the market hasn’t made new highs since the 10-year bond yield touched four year highs on January 29th? Not a chance. If rising interest rates spell disaster for stocks, there is likely more bad news on the horizon. With the details of President Trump’s 2019 budget plan out, Mick Mulvaney, White House budget director, has warned that the deficit built into this year’s budget could cause interest rates to “spike” even higher. What’s more, the Trump tax cuts and deregulation have led to record employment numbers and a sharp rise, if not a record-breaking uptrend, in economic growth. Both of these usually good news factors will spur the Fed to raise interest rates higher and sooner…
Given the fragile state of the stock market right now, a spike in rates could send it sharply lower. With key support levels such as the 100-day moving average already breached and a 200-day moving average breach in sight, things could get very ugly, very quickly. A look at how money has been flowing in the stock market over the past wo weeks shows that there are more than a few investors out there who think like I do. Now That The Party’s Over…What To Do Next?