The analogy I have used with clients in the past about markets that get overextended is that of stretching a rubber band too far. When it finally snaps, it can be painful. The almost 9-year bull market in North American stocks has been the most disliked in history, yet it’s allure was just too strong for retail investors in January and the flood of new money into the market was a sign that the party might be over. And the rubber band snapped hard.
As of Thursday night, the Dow Jones had just completed more than a 10% correction from its record high of 26,616 on January 26th. It had actually closed at the intraday high that same day. It dipped below the 24,000 mark on Monday and finally closed below that level on Thursday. What was looking like a year-to-date gain (over 7%) that was too good to be true, the index was down more than 3% before Asian markets opened on Friday. For the Dow, this is the first double-digit pullback since 2015, which was also the last calendar year the index fell.
Losses have reverberated around the globe, with European shares down 4% and Japanese stocks falling 6%. Of course, the TSX lagged again and was down 7% by Thursday evening. At its worst point on Tuesday, the index had virtually wiped out all of the gains made since August. Given that, investors may be surprised to hear that this is not yet a ‘correction’ for Canada, as the TSX is down only 8% from its historic high set in early January.
I am not going to go into the factors that led to this week’s meltdown as they have been amply covered in the media and were risks that we have talked about before (excessive move higher in bond yields, inflation concerns and late-cycle euphoria). The real culprits, however, were greed and ignorance.
Those terms may a little harsh, or obvious. As Michael Douglas’ character in Wall Street summed up—“Bulls make money. Bears make money. Pigs? They get slaughtered.” The MSCI World Equity had a total return of more than 20% in 2017 and it had delivered a return of over 7% by January 26th. That equates to an annualized return of about 150%. Put another way, markets had achieved what pension funds are mandated to produce each year on average (7.5%) in just a few weeks. When close to $85 billion of new money flowed into equity funds a couple of weeks ago, it was clear more pigs were coming to check out the trough.
There were those, however, that were correctly concerned about buying stocks at such lofty levels. Yet, they also spent too much time listening to bearish analysis of bonds. Instead, they ventured into products that offered up returns better than bonds. Crypto currencies fall into this camp, but there was a bigger play by retail investors into so-called ‘short volatility’ exchange traded funds and notes. This relatively recent invention was essentially a bet that the abnormally low market volatility that we saw last year would continue and, if so, investors would make money. In fact, they did for much of January, but then volatility began to edge up. As I have discussed many times, when we buy (go long) a security, the most we can lose is all our money. When we short something, the loss is theoretically unlimited. So, if you bet that volatility is going to stay low or go lower and it creeps higher, then the losses mount. Investors then have to close out or ‘cover’ their short investment. This means that they are buying volatility, which sends the price of volatility higher, and so on. In the chart I show the VelocityShares Daily Inverse VIX ETN, which has basically been wiped out, along with the money that investors put in to it.
To be sure there is a greed element to that, but the bigger lesson was how ignorance of a security can lead to disaster. We saw this with collateralized mortgages before the 2008 crisis and with leveraged ETFs after the fact. This lesson played a role in this recent correction too. It’s like going down to the basement to clean up after a wild teenager party. Once the empty cans and wrappers are swept away, the basement look normal and usable again. Same with the stock market, and now there may be some opportunities.
Canada: Existing home sales, manufacturing shipments
US: Monthly budget statement, NFIB small business sentiment, CPI, retail sales, Empire manufacturing, producer prices, Philly Fed index, industrial production, housing starts, building permits, University of Michigan sentiment
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