InnOvation Capital & Management, LLC
IntelDigest
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
FEBRUARY 14 , 2018
Contact Richard Power with comments or questions. IntelDigest is intended for the use of our clients and colleagues. Material may not be reproduced, forwarded or shared without express permission.
In this issue of IntelDigest, we address the recent action in the investment markets. As a matter of course, we provide periodic updates on markets and The Economy, with emphasis on prospects going forward. And, we will return to such analysis in the coming weeks.
Today, we look at the recent market turmoil. What does it mean? Does it signal the end of the long Bull Market?
Fundamentally Sound Markets
To start, we believe that the equity markets are fundamentally sound, and the “Melt Up” in the markets still has several months to run.
Conditions haven’t changed much since we wrote (on November 8 and December 6) that certain factors support the continued “Melt Up” of equities, both domestically and internationally, for another few months:
* low Interest rates
* improving economic conditions around the world
* strong earnings in the largest U.S. corporations
* positive technical indicators signifying continued strength … the Advance/Decline Line and market breadth moving up
And now, the potential for massive gains in Corporate America from provisions of the Tax Cuts and Jobs Act of 2017 (TCJA).
So, What Happened?
Since the calendar turned to February, we have experienced three days where equities markets dropped precipitously (2-4% per day), causing unease among investors. However, we see this as normal corrective behavior within the Bull Market.
After all, the S&P 500 had rallied more than 40% over the prior 24 months, without so much as a 5% decline. This has been an unprecedented winning streak. Markets go Up and Down in the ordinary course of events … a normal market correction has been long overdue.
The overall direction of the equities markets is still Up, for the reasons set forth at the beginning of this article.
The Real Cause of the Disquiet
Besides, recent events have had little to do with market fundamentals, and can be attributed to “Financial Gambles Gone Bad.” Many assumed that news on higher inflation spurred the initial sell-off on February 2. We’ll talk about Inflation next week; but, we believe that a form of Gambling set the markets on edge.
You have all heard about derivatives. They were at the center of the 2008 Financial Crisis. And, we believe that a form of derivatives caused the recent market unrest.
A derivative is a financial contract which derives its value from an underlying asset … essentially, “side bets” which traders and investors may make on market movements. Sounds innocent, doesn’t it?
Derivatives are written on stocks, bonds, currencies, commodities, Treasury notes, interest rates, et al. The most notorious were Collateralized Debt Obligations, primarily packaging real estate mortgages, which turned the world upside-down in 2008.
As long ago as 2002, Warren Buffet stated that, “… In our view … derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” In other words, derivatives can be dangerous if they become over-extended, or if misused. These strategies used to be restricted to professional futures traders. Now, millions of traders … many of whom lack sufficient understanding of the dangers … have the ability to “place bets” with derivatives.
We believe that the tsunami of selling which hit the markets earlier this month was caused by derivatives action related to the CBOE Volatility Index (VIX), commonly referred to as the “VIX.” Since 1993, the VIX index has been considered a premier barometer of investor sentiment and market volatility. VIX futures contracts and options were introduced in 2004 and 2006, respectively, ushering in an age when virtually anyone with a computer can place bets on market volatility.
Volatility Derivatives Trigger Chain Reaction
The long bull market has been uncharacteristically stable for the last 24 months, resulting in record-low volatility. So, the use of “short volatility” strategies has been unusually high. Essentially, these involve futures contracts, option contracts, and even exchange traded funds (ETF) which trade as easily as stocks and allow traders to make long-term, highly-leveraged bets on sustained market quiet.
As long as volatility stayed dormant, traders would make money, sometimes lots of money. However, at the beginning of February, volatility started to move up on news of a minor uptick in inflation data (again, we’ll discuss the prospects for inflation next week). It seems that a Chain Reaction of panic selling was started among volatility traders. As traders sold shares to offset their volatility risk, the market naturally fell lower. This caused more volatility, leading to more market selling.
Eventually, buyers stepped in to take advantage of the discounted stock prices, but not before steep declines had occurred in the markets, triggering panic on Wall Street.
The irony is that there was no political or geopolitical news, or financial news on the underlying stocks, causing the downturn. Many investors engaged in panic selling simply because the overall markets were trading lower. Market action was driven by math, rather than objective analysis; by futures contracts and algorithms, rather than by rational investment decision-making.
There is always the danger that a market panic could result when forced selling leads to more volatility, leading to more forced selling as futures dealers try to balance trades which have gone bad. However, the rational investor should understand:
* low Interest rates continue to undergird the health of the equities markets
* world economies are stable
* large corporations, especially in the U.S., are enjoying growing profitability
Under these conditions … which we expect to perpetuate through most of 2018 … we do not fear corrections in the markets.
Lower stock prices represent lower risks and better opportunities.