February 2018 – Monthly Commentary

April 23, 2018  |   Monthly Commentary   |     |   0 Comment

February 2018

Six weeks ago, as we closed out January, the S&P 500 Index settled just below its all time high. Financial pundits
at the time were saying that a healthy correction would be good for the market. The term healthy correction
has always seemed an oxymoron. How can a decrease in the value of one’s investment portfolio be
described as healthy? Yet, the term has been in the lexicon of Wall Street for as long as traders have been
able to short stocks. The state of the market since the first of February is a telling example of the lunacy of a
healthy pullback. Stocks plunged more than 10% in the first two weeks of February and despite having
bounced off of the low, nervousness still abounds as witnessed by the sharp intraday spikes higher and lower.
Anecdotal evidence suggests that ETF’s were at least partly to blame for the panic. We’ve written on
numerous occasions of retail investors bemoaning that stock valuations were too high and rather than buying
expensive stocks, have invested in an ETF instead. To be clear, the SPDR S&P 500 ETF invests in every stock in the
S&P 500, even the overvalued ones. To maintain the correct proportions, the ETF manager must buy in the
open market. When demand rises for an ETF, the buying pressure lifts the entire market. Conversely, when
investors dump the ETF, the manager must dump all of the stocks and in the instances we saw in February, the
result is a precipitous drop in the overall market value. Compounding the selloff was an excessively large short
position in stock index volatility (VIX and VIX-like) products. These products have become a fad with active
traders and we believe that many of those trading them did not fully understand the ramification of the risk.
The VIX is a proxy for the expected annualized volatility of the S&P 500 and has traded mostly below 10% since
last summer. Investors had been collecting income by buying an inverse structured note that went higher in
price as implied volatility fell. Viewed as a “no brainer” money maker, retail investors piled in. The problem was
that when stock prices fell, implied volatility rose, inflicting losses on the VIX sellers. The market makers of the
products were forced to buy offsetting positions in the open market which pushed the value of implied volatility
higher and had the collateral effect of further spooking ETF holders. In short order a vicious circle developed
which drove the price of the broad market 10% lower in the course of a week. Happily, corporations stepped
in to buy back stock at a ravenous rate, staunching the selling and emboldening investors with the confidence
to do what they’ve been conditioned to do since 2009. Namely, buy the dip!

While not directly responsible for equity weakness, newly sworn-in Fed Chairman Powell made his first public
comments in testimony before Congress and his remarks were interpreted as being decidedly hawkish. Before
the testimony, consensus opinion was for three rate hikes this year, with some members of the FOMC arguing
that even that was too hawkish. Since the testimony, the market now reflects 100 basis points of tightening this
year including one later this month at the March 21st meeting. That has translated directly into higher interest
rates, with 3-month LIBOR crossing the magical two percent level. Also adding upward pressure to short
maturity interest rates is the sharply higher amount of new T-bill issuance coming to the market. As we’ve
discussed last month, the U.S. government is going to need to finance their continued excessive deficit
spending and that means more debt issuance.

Also catching the eye of investors was the rise in the yield of the 10-year note as it approaches 3%. This is the
third time since 2012 that the yield has approached 3% only to reverse direction. We’ll be watching that level
closely. Quite often in markets when a price, or in this case yield, breaks through a resistance level on its third
attempt, it usually follows through in meaningful way. If we get through 3%, we could very well see 3.5% before
too long.