Putting Recent Market Sell-off in Perspective

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Markets have been unnerved by rising interest rates in the US, with ripple effects around the world. The most staggering event has happened on the VIX market with a number of funds/ETNs making the headlines after having lost tons of money. What should investors take from these events ? A couple of reflections and interesting comments seen here and there.

Why is this important ?

US markets have had six years of S&P rise without a drawdown of more than 4%. Per Morgan Stanley : « such a one-day sell-off for S&P is rare – only 13 years out of the last 50 have ever seen declines of this magnitude or worse. »

Valuation are still expensive, despite the sell-off

Last reading of Shiller P/E is 33.4x, which is huge, as as you know already, this is the level last seen in 1929 and 2000. So if earnings don’t follow suite properly and keep rising, well Houston we have a problem.

Are fundamentals changing ?

So are fundamentals changing? Not really. We are in the midst of the 4Q earnings season. Based on last monitoring from BofAML and consensus data, 4Q EPS is 3% ahead of consensus thanks to Technology and Healthcare sectors (Materials had good numbers overall as well). Based on 251 earnings reports representing 72% of S&P 500 EPS, there has been a 69% beat on EPS and 79% beat on sales.

Everything looks good at this point. Of course, sentiment is the key driver for markets here and high valuation are something you can’t turn a blind eye on. In the coming weeks, either VIX continues to rise and people get more and more nervous, get out of equities fast and big and drive the market correction further… Or the situation gets under control and the market get back on their feet and keep rising.

What’s the takeaway ? (brokers views)

From Morgan Stanley : « A reversal of vol from exceptionally low level poses challenges to strategies that have an explicit or implicit vol target. Both rates and equities are at risk from deleveraging of risk parity portfolios, but equities are more exposed to a renormalisation of volatility on this move. »

From Goldman Sachs (Feb 7th) :

« We view this as more a technical than fundamental sell-off, and still see bear market risk as low – our economists still see a low probability of recession and while our bear market risk indicator is at elevated levels it has remained range-bound, in part due to anchored inflation. Equity valuations have reset to the lower end of their range and current equity flows and equity-bond rotation are not yet consistent with levels before bear markets. »

From Merrill Lynch (which sent a « Sell Signal » on Feb 2 – nice call) :

« In our view markets had gone too far too fast two weeks ago and the correction is merely an unwind of very overbought conditions. »

« While we were short term cautious we said we remained positive on the outlook for 2018 as a whole. Global growth is still robust, our global wave has been rising for 20 months in a row and earnings revisions are solid. That is a backdrop where global equity markets should do well and we continue to look for double digit returns for 2018. »

Inflation remains the key risk. Bond markets know what Merrill is talking about.

Very interesting take from Nomura (published on Feb 7th) :

« There are two interpretations of these facts. First, the VIX is sending us a serious message about the outlook for short-term US equity returns that the market needs to pay attention too. Second, US equity volatility products are an asset class in their own right. The existence of levered short-vol carry positions in those markets makes them more exposed to relatively small changes in other asset classes, e.g., rates vol.

To the extent interpretation one is correct, we should see a large increase in long rates hedges and selling pressure in credit and EM. To the extent the second interpretation is correct we should expect, when the affected positions are removed, a return to the status quo ex ante. Feedback from discussions with market participants suggests most people are putting faith in the second interpretation; this was an isolated incident in an important derivatives market.

The evidence supports that case. But there’s a problem. And it’s the term premium. »

And they add :

« normalisation – whether cyclical or structural – means a higher term premium and higher rates volatility. Even while the absolute level of yields remains low the past few days tells us two important things: investment strategies habituated to low term premia are likely to struggle in this environment; and higher beta assets can rally as government yields rise so long as their risk premia fall faster than rates increase. If rates rise too quickly, all bets are off.

The speed and breadth of the recent recovery has left central banks with a communication problem – it is tough to forward guide a nervous bond market if inflation is rising and growth is well above trend. If a rising term premia has claimed its first victim, will there be others? Given the low absolute level of yields there’s little case for a growth driven risk sell off. But it is the speed of the adjustment to normal that will now be critical. »

Damage control

As usual, when such an abrupt movement in markets happens, some investors and funds suffer. A number of comments/observations on Twitter and elsewhere have pointed to the sharp fall in a number of funds or ETNs.

Yet the most important thing is 1. to be diversified ; 2. to hold cash and have more cash when markets are expensive so you can deploy it when they will become cheaper ; 3. to always work your valuation models so you can factor in the potential of a world recession which is in the end the main factor that will bring the next market collapse.

So far, we are not there yet, but the current market environment shows investors are getting more and more nervous. The bears might consider their time is coming and that what just happened is probably not just a blip, but rather the slow unfolding of an unsustainable situation (i.e. free money for all thanks to central banks). The bulls might see a blip and consider that as long as inflation doesn’t shoot up out of proportion, everything will be fine, because, well, central banks are watching.

 

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