By Pete Biebel, Senior Vice PresidentPrint This Post
The first full trading week of 2019 enjoyed a hearty and healthy continuation of the post-Christmas rally. The major averages rang up gains of about 2 ½% to about 3 ½%. The steep December skid left the market extremely over-sold with extremely negative sentiment as of the end of trading on Christmas Eve. But, since then, stocks have been heading north faster than Santa’s sleigh. Trade talks, a partial government shutdown, political slapstick squabbling over potential border wall funding, and big swings in the market’s understanding of the FOMC’s intentions, have certainly been distractions, but they haven’t swayed the sleigh from its northerly route.
Some of the most badly bruised sectors had the most surprising recoveries. The Oil Services subsector had been trending lower since its high in May 2018. That group cratered another 50% from early-October into late-December as the price of crude oil tanked. But, the Oil Services sector has rallied back about 25% since then, including about an 8% gain just last week. The NASDAQ Biotech Index had been trending higher through 2018 and reached its highest level in three years as October began. The late 2018 slide lopped about 25% of that index into the Christmas holiday. The group has recovered about 22% since Christmas including about an 8% gain just last week.
The rebound in the overall market hasn’t been quite that spectacular but it still has been very impressive. It’s delivered much larger and much quicker gains than most expected. Then again, the averages were very washed-out at the December low, so a healthy snap back was not unexpected. I’ll get into more detail on this topic in a minute.
The title of this week’s blurb refers to a couple Wall Street Journal articles that were published last week. The first one that caught my eye was “Computer Models to Investors: Short Everything.” The article describes how trend-following trading systems have recently swung from bullish and “Turned Bearish at Swiftest Pace Since 2008 as Machines Steer More Trades.” Just to be clear, that swing occurred over a three to four-month period as the market averages descended from their highs. And, yes, I expect that much more of the day-to-day trading activity now is computer-driven than was the case ten years ago.
The key information in the article is that system-based selling contributed significantly to the size and speed of the market decline. In recent months I have written several times about how the mechanical, automatic, systematic buying, which was a force behind the market gains for the past several years, irrespective of “value,” had suddenly become mechanical, automatic selling irrespective of value. Such selling, triggered as the market indices took out critical levels, was a significant part of the steep downdrafts in the market through October and December.
A few things that are important to keep in mind about this phenomenon. All the trades are based solely on price and price-derived indicators; they occur irrespective of the fundamental valuation of the stocks/indices. When the triggers click, the machine fires off an order. These algorithms will tend to pay too much for stocks near the end of an uptrend and sell them too cheaply near the end of a down trend. They are trend agnostic; they don’t much care which way the market goes. They just hope that once a trend begins, it will last for a while. These systems will do almost exactly as much buying in uptrends as selling in downtrends.
Despite its menacing title, I think the article is potentially good news for the market for several reasons. The fourth-quarter downdraft has likely forced the trend-following systems into their most bearish posture. In other words, they’re not likely to do a lot more selling. Perhaps a more important conclusion that can be drawn from the article is that all those trend-following systems represent a lot of potential buying power at some point in the future if/when market trends swing back to positive. And, because the selling is driven by “price” as opposed to “value,” extreme shifts, like those in October and December, can drive stock prices down to levels that represent solid fundamental bargains.
The second article, “Volatility Signal Flashes Red, Even as Stocks Rebound,” naively perpetuates the myth that there are significant implications in an “inverted VIX curve.” VIX is the CBOE Volatility Index, which measures the market’s expectations for future volatility. Since 2004, exchange-traded futures contracts have been available for anyone who wanted to bet on where VIX levels would be in the weeks and months and years ahead.
The article suggests that, because short-term VIX futures are trading at price levels above longer-term VIX futures (an “inverted curve”), it is flashing some kind of danger signal. That myth has grown out of the significance that is attached to an inverted yield curve. Inversion of that curve (i.e. when short-term interest rates are higher than longer-term rates) is unusual and is often eventually followed by an economic recession. Please keep in mind that the natural state for interest rates is to have longer rates higher than short-term interest rates. 20-year bonds of any particular issuer will have a higher yield than the same company’s 5-year notes. 30-year mortgages have a higher interest rates than contemporaneous 15-year mortgages. Investors/lenders need to be paid more for the higher risk of longer dated loans. When that natural state is upset, it suggests that something is very wrong, and is therefore a useful if infrequent alarm bell.
But trying to draw anywhere near that level of significance from an inverted VIX curve is illogical. The natural state for a volatility curve is for the longer contracts to always have much narrower price fluctuations than the short-term contracts. Imagine that there were futures contracts for the average of the average daily temperatures in Chicago between now and the contract’s expiration. The price swings in the one, two and three-month contracts could move around quite a bit, just a handful of abnormal days could skew the average over the short-term. Conversely, price swings in two, three and four-year contracts would be infinitesimal, almost non-existent. There would be no reason to bet against the long-run average. There will be extra hot days and very cold days in the coming months, but they’ll tend to average out over the long run.
Short-term spikes in volatility come and go, but they are never so extreme, or so likely to continue for months or years, that they have a significant impact on long-term expectations. So, Every Single Time that short-term VIX spikes into the low-20s or higher, it will almost surely result in an inverted VIX curve. All it means is that the then current short-term volatility expectations are high for some reason, but they’re not expected to stay that way for months on end. So, the myth is that every time the VIX curve inverts, it’s flashing a red alert. Actually, all it really means is that short-term VIX is temporarily inflated.
The post-Christmas rebound has lifted the S&P 500 Index (SPX) to just above the top of my expected rebound range. I guessed that index would rally into the 2525 – 2575 range. SPX climbed above 2575 last Wednesday and remained in the 2585 – 2595 range for most of the balance of the week. SPX ended the week near 2596. My next upside target area is the 2625 – 2635 range. If SPX can somehow climb above the 2650 level, it would be a very encouraging sign for the bulls.
We should expect that, following the 2 ½ weeks of chugging higher, the market may be overdue for a bit of a breather. Short-term pullbacks could dip as low as the 2500 – 2520 range and not negate the potential for a higher rebound high.
The market’s version of a visit to the candy store, the new Earnings Season, opens for business this week. Each day brings new treats, but for the first time in years, there’s an increased potential for the number of sweet tidings to be reduced by more than a few sour reports.
|Tuesday 1/15/2019||Producer Price Index – Final Demand, M/M||+0.1%||-0.1%|
|PPI – Final Demand, less Food & Energy, M/M||+0.3%||+0.2%|
|Empire State Manufacturing Survey||10.9||12.0|
|Wednesday 1/16/2019||Retail Sales, M/M||+0.2%||+0.2%|
|Retail Sales, less Autos & Gas, M/M||+0.5%||+0.4%|
|Import & Export Prices, Imports, M/M||-1.6%||-0.9%|
|Import & Export Prices, Imports, M/M||-0.9%||-0.3%|
|Business Inventories, M/M||+0.6%||+0.3%|
|Housing Market Index||56||57|
|FOMC Beige Book|
|Thursday 1/17/2019||Initial Jobless Claim||216K|
|Housing Starts, SAAR||1.256mm||1.256mm|
|Philadelphia Fed Business Outlook Survey||9.4||10.0|
|Friday 1/18/2019||Industrial Production, Production, M/M||+0.6%||+0.3%|
|Industrial Production, Manufacturing, M/M||0.0%||+0.1%|
Links to previously published commentaries can be found at benjaminfedwards.com/Company News/Blog/Market.