Wednesday, February 7, 2018

This Week's Message: The Basics of This Particular Selloff, And Sour Grapes for Flat Footed Gurus

The last few days have seen a remarkable – relative to very recent history – selloff. Based on media accounts you’d think we’re seeing a shakeup that rivals history’s “worst”. When, in fact, this is the fifth time during the current bull market where a 7-day stretch has seen at least a 7% drawdown.

The question of course is, do present conditions suggest that this could be the beginning of something far more pernicious? While it’s of course within the realm of possibilities, the answer from the data is a resounding no.

The bottom line in our view is that the world has woken to the fact that the global economy is in very good shape, that central banks will, therefore, not be easing going forward, and that bonds have enjoyed a 30-year bull market that virtually has to – under present macro circumstances – come to an end. Meaning, the equity markets of the world will have to contend with all that higher interest rates bring; which in the early stages typically does not provide the makings of a bear market: As, typically, the early stages are characterized/caused by healthy economic growth; which translates to healthy profit growth sufficient to offset the negative effects higher rates have on equity valuations.

Nevertheless, a truly rising long-term trend in interest rates – if that’s what we’re in for (of course there have been spikes throughout the declining long-term trend in rates– is simply different than what market participants have grown accustomed to. Add in the fact that we were experiencing a record period of low volatility, and suddenly you had folks clinging to gains like kids cling to their cell phones. I.e., a lot of players freaked out and sold.

But the true freaking out appears to have occurred among the programs written by really smart folks who through rapid computer trading exploit existing intermarket trends; such as excessively low volatility. Problem for them is, when a sea change occurs, massive dislocations occur, and, thus, they can realize massive losses. So they abandon ship, all at once! The “problem” for short-term thinkers (never you and me) being, that all at once selling pushed massive amounts of shares into the water at a time when there weren’t nearly enough life boats (buyers) available to save every passenger.

As for the complainers who rail against algorithmic, and derivatives, traders: As happens every time the gurus find themselves flatfooted, high-profile pundits scream foul at the math wizzes who create those high-frequency – sometimes derivatives-laden – trading “black boxes”; while conveniently leaving out the fact that under normal conditions these hedge funds provide the market with additional liquidity. I personally see their complaining as the definition of sour grapes. I say if you can run a program that profitably exploits present intermarket relationships, more power to ya! I think it actually makes the market truer, and better.

A related narrative has to do with a variety of exchange traded funds (ETF) that effectively take away the complex execution strategies one would otherwise need to, say, short the VIX (S&P 500 volatility index). That is, a trader (unsuspecting or otherwise) can buy an ETF that essentially bets that the VIX will drop, or stay very low, and make a killing as long as volatility doesn't spike big time while he/she holds the shares. Theory has it that the implosion of two such ETFs had more than a little to do with Monday's crazy action toward the close. 

Flat footed gurus are leveraging the ETF theory (and it is plausible mind you) to scream their bloody murder. Sour grapes? Well, okay, I can give em this one, but I sure wouldn't opt for new rules to keep such products off the shelves. If there's demand for such things, and folks do their due diligence and know the risk their taking, I think the market should accommodate that demand. If they don't fit your objectives (they don't mine), then don't go there. And to the extent that they cause a little, or a lot, of volatility, know that conditions have to be ripe to allow for that kind of volatility to begin with, I don't care what the gurus say.

As we keep preaching, we were WAY overdue for some frightening turbulence. Now we're getting it, we think it's good, and we remain focused on the big picture -- meaning, we're really not obsessed with the whys of Monday's price swings.

Have a great rest of your week!

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