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Just to give you guys a flavor of sentiment in the industry:
Very widely held belief that this was a technical and borderline healthy adjustment. Markets periodically go through something called a VaR shock, which in simple terms means a low vol environment leads to a larger build-up of positions and leverage to achieve the same return, only to see vol spike and then those positions need to similarly be scaled down (often at the worst possible time with everyone heading for the exit at the same moment). The people who rushed into inverse levered ETNs on the VIX were probably largely responsible for the truth depths of the sell off on Monday. Other "culprits" include CTAs (as I mentioned before, momentum-following accounts who have been feasting on broader macro trends this year) and Risk Parity (in simple terms, balanced funds who run long equity and long fixed income strategies normalized by volatility; Bridgewater is the largest).
People cite the strong fundamentals, etc and think that the pace of gains will slow from here but the general direction is higher.
My main concern with the above narrative is simply how widely it's shared. For several years the post-crisis landscape was dominated by central banks buying assets - primarily low risk but not always the case - and depriving investors of their return. Those investors who sold a US Treasury to the Fed for example were crowded out and then bought a corporate bond. Then the person who sold the corporate bond needed something to buy and he bought equities. This is called the 'portfolio balance channel.'
In any case, we're well past the crisis and central banks are beginning to dial back this sort of stimulus. The narrative, say, 3-4yrs ago was that risk assets benefited from this sort of easing, and when it's unwound, those same assets should suffer. Pretty basic mirror image (there are of course flaws in that logic). But as the Fed has hiked 125bps and is now running down its balance sheet of assets, equities and credit haven't blinked.
I think this has lulled people into the belief that the monetary policy unwind would be a complete non-event for risk assets (e.g., equities, credit). My concern is that the jitter we saw this week - which perhaps not uncoincidentally was preceded by the highest Treasury 10y yield since early 2014 - was the first shot across the bow to challenge that belief. Markets tend to trade certain themes when they choose to, and if you told me 6 months from now equities were languishing a little bit lower and people were citing this as the cause, I wouldn't be surprised for a second. The market is chalking this all up to be a technical sell-off but I'm not entirely convinced (though I do agree it's entirely possible).
Consider this: the Fed influences the economy through financial conditions, which you can think of as the stimulatory impact of equities (higher = better), credit rates (lower = better), and the dollar (lower = better). Since the Fed started hiking rates in late 2015 to gently slow the economy, financial conditions have actually become significantly easier. I.e., it has gone in the complete opposite direction that you would normally expect given the strong bid to equities and the ever-narrowing credit spreads to Treasuries (the dollar recently has also been contributing positively). So the Fed is trying to slow the economy, but their lever to do so isn't working.
Anyway, the above is just to say that the market is likely to be bumpier in the months ahead. I'm hardly trying to be a Cassandra here but you have literally just gone through one of the most impressive market moves in generations. Some details on that (credit Tony P at Goldman Sachs):
- the gross return of S&P in 2017 was +19.4%. including a dividend stream of 2.4%, the total return of S&P was +21.8%; this ranks as 78th percentile since 1962.
- realized volatility was 6.7%, the second lowest on record (1964 = 5.2%).
- the vol-adjusted total return of 3.3 ranks second only to 1995 (when the S&P returned 38% on 8% vol).
- the median daily market move was just 0.18% -- the smallest on record -- and the largest peak-to-trough drawdown was 2.8%, the mildest since 2.5% in 1995.
- wire-to-wire: the market didn’t trade negative at any point in the year, marking just the 10th such occurrence since 1928 (the most recent being 2013).
- 58% of days were up days (93rd percentile).
- for the first time on record, the S&P delivered a positive total return in each and every month this year.
Hope maybe this provides some useful perspective somewhere.
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