Forest fires are terrifying to witness. Having lived in California for a couple of years in the mid 2000’s, I didn’t have to go far to find traces of nature’s fury given the dry climate. Once started, forest fires have little hope of being extinguished by human efforts – only contained. The goal of the heroic fire crews that battle the inferno is to “control burn” as much fuel in advance of the actual blaze so that there is nothing left to burn once the fire arrives. There is no doubt, on seeing an actual forest fire from a distance or its aftermath, that the intensity is high, the path is indiscriminate, and the damage is quick but severe.
Activity in global equities over the past three trading sessions (February 2nd, 5th, and 6th) is allegorical to forest fires, seeing steep daily declines in stocks for seemingly no reason. Yet, was there really no reason for the recent declines? As we’ve indicated since Q4 of 2017, the fuel for the recent forest fire was created through the combination of (1) excessively high investor sentiment, (2) exceedingly low volatility (e.g., VIX), and (3) large money flows into stocks. Each one of these, alone, was not problematic, but all combined made a different situation entirely. Incidentally, observation of the conditions above led our Investment Committee to recommend a portfolio rebalance prior to the recent drop.
What sparked the sell-off?
While pinpointing the exact reason is almost impossible, the most likely source of the recent selling pressure has been the upward movement in US interest rates. As can be seen in the chart below, recent moves in the 10yr US Treasury bond have brought rates to near 3%, a level not seen since 2013 during the so-called “taper tantrum.” Higher rates become an issue because, at some point, bonds become competitive with stocks for portfolio allocations.
In our opinion, the other root cause of the sell-off has to do with the unwinding of the short volatility trade that has been very popular with both hedge funds and pension funds. Essentially, since the “flash crash” (which occurred in late 2015), volatility in the options markets (as measured by the VIX index, seen below) has moved to extremely low levels. This low reading in the VIX index signals that portfolio hedging with options has not been occurring to any significant degree. Further, this expectation of low future volatility was being speculated on by many (to include pension funds) as a way to enhance return in a portfolio. The problem with this strategy, however, is that once investors begin to unwind these speculative VIX positions, this process creates a positive feedback loop sending volatility higher. Many taking these speculative positions may have only fully realized the risks inherent in such a strategy once the sell-off began.
Where do we go from here?
Just like in a forest fire, while the intensity is high and the moves are erratic, we don’t see the selling pressure lasting for much longer once the fuel of interest rate movements and VIX position unwinding dissipates. That is not to say that equity markets could not move lower from here over the near term. But given the tinder of suppressed volatility, low interest rates, and excessive investor sentiment, a garden variety correction in the 5-10% range makes sense. On the other side of this current corrective phase for equity markets, the excesses will have been cleared out, allowing investors to focus on some of the positive factors present in the markets. In our view, global equity markets can move higher over the remainder of the year based on a combination of the following positive dynamics:
(1) Global earnings and revenue growth are strong
(2) All major economic regions around the globe are in a synchronized expansion
(3) US Interest rates aren’t rising in a disorderly manner
(4) High Yield bonds aren’t signaling duress
(5) Global inflation remains modest (between 2-3%)
In summary, as we await the culmination of the current corrective phase in equity markets, we would like to highlight that periods like this underscore the need for diversified investment portfolios. This diversification includes allocations to cash, fixed income and, where appropriate, alternative assets. Specific to cash holdings, most portfolios have been positioned with elevated cash levels due to our recent rebalancing activity. This cash will give us optionality in the case that equity prices decide to move markedly further from current levels. We’ll look to redeploy this cash as opportunities arise.
As we approach the final stages of the current bull market, episodes like the one we currently find ourselves in should be considered the norm as opposed to the exception. This heightened level of equity volatility will test resolve and challenge investor convictions, which is why we’ve been revisiting client risk profiles and cash flow goals in recent months. Rest assured, we are mindful of many of the risks being discussed in the equity markets. If the fundamentals of this aging economic recovery change then we will take appropriate action. For now, we need to let the fire burn the accumulated tinder on the forest floor so that we can move higher from here.
Gratus Capital is an SEC-registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request. The opinions expressed are as of February 2018 and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities. No graph or chart by itself can be used to determine which securities to buy or sell or when to buy or sell them. As with any investments, past performance is not a guarantee of future results. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.