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Floating in a most peculiar way

The Days Ahead: More vol. U.S. CPI: We get to see if there’s any inflation.

We're writing this Friday after a tough week. Yes, there was a return of volatility and corrections. Only 32 S&P 500 stocks are up on the week and 18 of those by less than 1%. Most stock indices are in the red for the year, except some Emerging and European markets. The Euro and Yen continued to strengthen.

So what’s still in place?

  • Economy heading up
  • Earnings coming through. The market is cheaper now than it has been in nearly three years. Put that down to a 15% increase in earnings
  • Bond yields are stable around a 50bp band (yes, in a low yield environment)
  • Global growth upswing
  • But…

1.     We have to talk Monday: We had a minor market meltdown on Monday. Like many of these, the explanations that roll in over the next few days are many and plausible. But the truth is, when they're going on, no one has any idea why a market goes down so violently.

  • In 1987, it was something called portfolio insurance. But on the day, barely anyone had heard of those esoteric and thankfully defunct instruments.
  • There was a near 2000-point drop in the Dow in August 2015, a 10% correction. That started with a 36% drop in China. What caused that? Well, fears of a Fed tightening, low copper prices and a weak Renminbi. But…no one was saying that in real time. It was just one sell order after another.
  • Flash crash in 2010? When the Dow fell 1000 points in minutes on May 6, 2010, I was on the NYSE floor and no one said “Oh, it’s a bloke sitting in his London suburban bedroom, quietly spoofing and front running.” No, it was full-on panic.

So, post-hoc explanations are easy. Real-time explanations are confused.

But we do have a smoking gun of sorts. For some time, stock volatility has been low, as in below 10 on the VIX and almost no correction or down day. Up to late November 2017, the S&P 500 hadn't moved more than 1% for 54 straight days. And there had not been a 5% correction for 396 days. The last time we went that long without one was 1996 (“Wannabe” by the Spice Girls) and before that 1965 (“Ticket to Ride”).

So, if you think low volatility is here to stay, you sell volatility and plan to rebuy it at a lower price. Some big managers believed this and traded volatility in their funds…here’s PIMCO on the subject.

Then some fund companies said, “Hey, this low vol game looks fun. Let’s create an ETF so punters can trade volatility. But let’s make it interesting and lever it up and have it make money when the market goes down. The marketing folk will love it and investors will make money when things go down. We'll charge 4.9% because, er…we can.” And that's how Velocity Shares Inverse VIX (ticker XIV, geddit?) and ProShares Short VIX Short-Term Futures (SVXY) came to be born and attracted and $3.6bn assets.

Now, the basic problem was that the funds bet on the VIX going down. It didn't. And after the business close, the futures they bought for the day were worthless and so the ETF closed at $6.00 having opened at $115. But investors weren’t finished because they then shorted the ETF overnight, which sent the VIX higher and that meant Credit Suisse (aka Velocity) had to liquidate the fund for pennies on the dollar. Game over and thanks for playing.

Oh, and Credit Suisse’s stock dropped 10%. If you happen to own it, don't. It’s worth less than it was in 1985.

These ETFs aren't really ETFs at all. They're ETNs. The “N” stands for note and that means it’s unsecured. When you buy an ETF of, say, the S&P 500, you buy a sliver of Apple, Google and all the way down to Pitney Bowes. When you buy an ETN, you get cash at the end of the day and the cash is determined by how much the futures were worth at the end of the day. You never own the future, you own the cash. They don't always track the index very well either. Velocity’s VIX long fund is up 28% this week. Nice. But the actual VIX is up 41%.

Anyway, we feel that volatility had been a coiled spring for months (one reason we kept Treasuries) and would unwind quickly. This is what the S&P 500 looked liked on Tuesday:

Remember, we hadn't seen a 1% day for months and then we had six 1% moves in a day. To give an idea, the MACD (it measures moving averages) graph scale is about 10 times bigger than normal.

So, we have some volatility, which is good because it flushes out complacency. But we do not have “fear.” A fear trade is when gold, the Yen, the VIX and Treasuries all rally. As this shows, only VIX was active on Monday.

In September 2008 (the Lehman crisis) all four went through the roof.

What have we learned?

1.     Volatility is normal for equities. If it stays too low for too long, it will return.

2.     When markets are moving fast in one direction, it’s best to stay out of the way.

3.     No important fundamentals changed (inflation, employment and growth).

4.     Profit taking is normal.

5.     New financial instruments (ETNs this time, CDOs in 2008 etc.) create risk.

6.     Short-term investors (the ETNs, the hedge funds) can distort prices.  They are not investors.

7.     Volatility is back. As it should be.

2.     What ticked up inflation fears? It is no accident that the correction occurred on the same day as Jerome Powell was sworn in as Fed Chair. Markets like to test the resolve of a new Chair. Will he keep with the rate hikes if stocks crater? We don't know yet. The market would have to fall longer and deeper.

We do know the Fed is on the look out for inflation. They can't find it in PCE or CPI. One area is in wage inflation and last Friday, the average hourly earnings rate jumped up 2.9%.

That’s it over on the right-hand side. Now I have a problem with this.

First, yes, it’s up year-over-year but these are not adjusted for inflation. Real hourly earnings are published separately and they're up 0.3%. 

Second, look at the numbers to the left of the 2.9%. Nothing to write home about. The 2.9% number may just be some catch up. The six-month moving average is stuck around 2.5%.

Third, the biggest gains are in some pretty low-paid industries. The average hourly rate for hospitality workers (11% of the work force and with a 7% unemployment rate) is $15.73 and they work 24.9 hours a week…so $19,580 a year. A 3% increase is an extra $11.70 a week.

Fourth, average hours worked fell. We've made this point before. If you’re paid 10% more but you work four hours less, you have no more money. But the BLS says, nope, you got a pay raise.

Anyway, we could go on, but the takeaway is that deflationary forces remain in play, there’s no wage increases, we don't think companies are about to give them and the workforce is still under utilized. These are not the conditions for wage push inflation.

Bottom Line: Not to be that guy who says “ Remain calm, don't make any rash decisions” but we think that most of this week’s movement was a healthy return of volatility and a better pricing of some of the new risks (e.g. deficits, shut-downs, can kicking). It’s one reason why we like Treasuries in the portfolio and would remain with them.

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Fed to Wells Fargo: Stop growing

And writes Stumpf a letter  

--Christian Thwaites, Brouwer & Janachowski, LLC

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