Why did global Stockmarkets sell-off so sharply last week?
In our September monthly update we wrote “A feature of equity markets over recent months has been the growing disconnect between the US and other global regions….the US is clearly the leading region and we always need to monitor the leader closely for signs of weakening.”
Last week the U.S. market fell heavily on Wednesday and Thursday, suffering it’s biggest two-day decline since February with other global markets following the U.S. lower. As mentioned, when the leading region shows signs of weakness it is a concern and here we examine last week’s sell-off with particular emphasis on the U.S. market and ask is this a correction or the beginning of something more serious?
All of the damage last week occurred in just two days and it is the size and speed of that decline that has many investors worried. Rising interest rates, forthcoming mid-term elections and ongoing trade tensions with China were cited as contributing factors. Maybe it was a combination of all these and the recent rate hike just triggered the market into a rapid re-adjustment but in the main the concerns we mention have been present for a while, so why was the decline so swift?
Some commentators blame systematic strategies for compounding the losses last week. These are trading programs that use volatility to determine their position sizes, and when volatility rises they will sell to adjust – unfortunately they all tend to do this at the same time if there is a quick market decline. Another possible reason for the exaggerated decline could have been extreme bets in the futures market. Specifically bets that the market would remain stable or move higher. One way for traders to back this bullish view is by shorting (betting against) the VIX. The VIX, also known as the Volatility Index or Fear Gauge, will spike higher if the market sells-off sharply. So by betting against the VIX you are in effect betting on the market not selling-off. Earlier in the month positions like this had reached extreme levels (as they did in January). The market sell-off on Wednesday saw the VIX spike higher which meant short VIX positions were experiencing large losses and traders rushed to cover their positions. This in itself has an impact in the S&P futures market and in turn on equities creating an accelerating cycle that can quickly send the market into a spiral down.
In the chart below you will see the S&P 500 at the top with Asset Managers short VIX contracts at the bottom. Note the spike in January and again recently.
Click on charts to enlarge them.
Is a U.S. recession expected soon?
U.S. Economic Data remains strong. The vast consensus of opinion says an imminent recession is not likely. Leading economic indicators tend to coincide with the stock market and will start to fade ahead of a recession. In the main this is not happening, leading economic indicators are improving – for example, the latest data for the Conference Board Leading Economic Index® (LEI) for the U.S. increased to a new cycle high. This from their Director of Business Cycles “The leading indicators are consistent with a solid growth scenario in the second half of 2018 and at this stage of a maturing business cycle in the US, it doesn’t get much better than this.” Bear markets and severe Stockmarket declines usually occur when a recession is expected or has already started. Having said that the dangerous unknown in all this is how bad a trade war between the U.S. and China could become. This is a potential bull killer even with strong economic data.
Can technical analysis tell us something useful?
The chart below shows the U.S. S&P 500 Index over the last twelve months. You will see the 200 day moving average plotted in red. A market decline to test the 200dyma is considered by most market technicians to be “normal” and does not change the long-term trend in a strong market, see earlier in the year. Because it is such a widely followed indicator many would say it has an influence itself on buying and selling behaviour, but in any case, time spent below that moving average will likely cause concern and may trigger more selling. For now at least we can say the market is “at Support” and we will see how it reacts.
Interestingly, we have our own (static) Support levels for the U.S. market which have been in place for months and these came into play last week as well. As follows: for the S&P 500 ETF the level is 271.70 and for the Russell 2000 (small-cap) ETF the Support is at 153.50. Both these levels were briefly tested on Thursday and capped the downside for these charts. The combination of the 200day ma and our long-term Support points provides us with useful levels to monitor.
What about current Market Sentiment Indicators?
Firstly, remember that Market Sentiment indicators are interpreted from a contrarian point of view, e.g. when they are registering a very high level of bearish sentiment that usually marks a point where the market is likely to rally. We follows these measures on various timeframes and our longer term indicators are not currently registering extreme levels of bears. This could simply be because they are released on a weekly basis and the latest numbers were available mid-week, last week, and did not register any reaction to the sell-off on Wednesday/Thursday. However in the shorter timeframe there was a clear reaction. For example, the CNN Fear and Greed Index fell quickly from a recent reading of “Greed” to “Extreme Fear” last week. Another is the level of Volume that we saw in many Inverse ETFs. These are instruments that allow the buyer to profit from falling stock prices. They are used by speculators but also by hedgers. However, extreme levels of buying will often indicate panic and mark a low of some degree for the market. Below we chart the S&P 500 ETF along with the Volume for the Inverse S&P 500 ETF. You can see that since 2009, Inverse ETF Volume similar to that seen last week has been close to the point where the market bounces. The question is, will this be the case again or has the tone of the market changed.
As you probably know, in the short-term, we place an emphasis on the technical aspects of the analysis and it is most important for us right now to monitor the Support levels discussed above. We have raised cash recently, and if those levels are broken we would be looking to take further defensive action.
Disclaimer: ‘Where the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice. The information contained within this communication is believed to be reliable but Realm Investment Management Limited does not warrant its completeness or accuracy.
This communication is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell investments.’