NOTE ON TODAY’S MARKET ACTION
Equity markets around the world are under pressure, with many experiencing declines of 5% or more over the past two trading sessions.
Our view is that nothing has changed substantially from our previously stated financial market, economic, or valuation perspectives. Our work indicated that risks were high and that large cash/bond allocations were warranted in our strategies to manage those potential risks. At this point, we continue to hold those defensive positions.
Overall, from the positive side of the ledger, we still see (partial list):
- Decent global economic growth ahead
- Good earnings opportunities around the world
- Potential benefits from tax reform for consumers and corporations
- Continued confidence from consumers and businesses
- Historically low interest rates
- Weak dollar helping U.S. companies doing business abroad
On the negative side, we see (partial list):
- Somewhat expensive valuations
- Interest rates creeping higher (though still relatively low)
- Central Banks around the world beginning to normalize monetary policies (though still accommodative overall)
- Very minor inflationary pressures
- Continued political and cultural risks
The recent selloff seems due more to several technical aspects of the financial markets, such as:
- Optimistic sentiment extremes being reversed (there was just too much investor optimism to be sustained and, historically, these levels have to be worked off before the markets can mount another move higher)
- Technical levels being breached (for example, many global 50-day moving averages were violated, leading to forced selling from quantitative investors who use these types of indicators to make decisions)
- Risk parity-related funds and strategies being forced to reduce risk. Due to stock and bond prices heading lower together (usually, they head in opposite directions, i.e., negative correlation), those firms that utilize this investment strategy were forced to sell stocks and bonds since one wasn’t going up while the other was going down (inclusive of volatility adjustments). These rebalances can, and have, caused quick, exaggerated moves in the market.
- Several investors, strategies and funds have been shorting volatility without hedging their risk. In my personal view, this is what is contributing most to today’s market action. Those investors are scrambling to buy back those short volatility bets that they made. This is typically a short-term phenomenon, as positioning usually gets squared away pretty quickly.
- Keep in mind, a lot of today’s action was due to portfolio managers of different technical stripes struggling to keep their portfolios within their mandated risk parameters. Importantly, this type of portfolio management has very little to do with valuation, economic activity or other fundamental inputs that relate to how businesses actually make profits and return cash to shareholders.
- There will likely be more portfolio adjustments to come as portfolio managers continue to balance their risks, as volatility is now much higher and will be a more difficult factor to contend with. However, this type of “market rebalancing” tends to be swift and probably won’t mark the end of the current secular bull market. (Note: Art Huprich, our Chief Market Technician, remarked that at the market peak on January 26, many broad market Advance-Decline Lines confirmed the index highs. This would support the notion that the current decline is more technical in nature as opposed to it being the result of divergences and underlying weakness.)
- We are noting short-term model readings that indicate that bonds may soon stabilize near term. In other words, interest rates may stop going up for the time being. That would be bullish for stocks.
- Additionally, we also see some signs that the U.S. dollar may also find a floor on a short-term basis. This would also be bullish for bond prices and as long as the dollar doesn’t move substantially higher, and may help stocks.
- The recent decline may also be the result of investors moving into index funds and ETFs. It has been widely documented that investors tend to underappreciate the risks attendant to those types of investments. Now that there has been the first meaningful decline in a year and a half, many of those same investors who bought funds thinking they were low risk are likely to sell them as emotionally as they bought them. It reminds us of the old market axiom whereupon someone yells “Fire” in a crowded movie theater.
- Corrections actually do happen during bull markets, though you wouldn’t know it by the market’s steady advance over the past year or so. Since 1900, according to Ned Davis Research, the largest DJIA correction in each of the bull markets during that period has averaged -11.0% over approximately 38 days. The last was from 4/20/2016 through 6/27/2016, when the DJIA fell -5.3% over 68 days. It is normal, and if we were to be down over 10%, we would view it as an opportunity to put some of our cash to work—as long as our models confirm that it is the right thing to do.
Overall, many of the very short-term technical indicators we follow indicate that this decline may soon find a floor. However, we will continue to monitor our models for signals that it is time to add to or time to reduce our equity exposure.
For those of you who would like more details, we are hosting our Monthly Macroeconomic Webinar on Wednesday, February 7th at 4:15 EST. Register for the webinar at https://attendee.gotowebinar.com/register/1519757454981315842
On Thursday, February 8th, we will be hosting a Day Hagan Logix Tactical Dividend Portfolio Update Webinar at 3:30 EST. Register for the webinar at https://attendee.gotowebinar.com/register/7058649534549531395
For more information and to register, please go to our website, www.dayhagan.com.
Donald L. Hagan, CFA
PDF Copy of the article: Day Hagan Market Update 02.05.2018 (PDF)
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