Regions Wealth Management


Stocks: Beware the Ides of - February?

February 2018

The S&P 500 jumped 7.5% through the first 26 days of the year, which according to Strategas Research Partners would have ranked as the 5th strongest January to open a calendar year since 1950 - if the gains had held. But, alas, all good things must come to an end, and a sharp move higher in interest rates took hold to close out the month, leading to a significant downdraft in global equities through the first few trading days of February. The S&P 500 plummeted from up 7.5% at one point on January 26, to down 0.92% in the subsequent six trading days. The sharp reversal in equity prices, as painful and unsettling as it has been, appears to be disconnected from economic fundamentals and in our view is based primarily on large institutional investors and hedge funds unwinding variations of a trade whereby they bet on lower and lower market volatility by selling futures or put options on stocks or volatility, while using those proceeds to buy more and more stock – a levered bet. Leverage employed is a double-edged sword as it can generate higher returns when things are going good, i.e. volatility is moving lower and stock prices are moving higher, but once the trade goes south investors/traders are forced to sell stocks to cover margin requirements or unwind the trade.

As noted above, and contributing in no small part to the unwinding of the popular 2017 volatility trade was the 10-year U.S. Treasury yield (finally) breaking through 2.7% to the upside in a big way, trading up to 2.85% before catching a flight to safety bid as stocks sold-off. High yielding equity sectors such as utilities, telecom, and REITs initially bore the brunt of rising interest rates with each posting a negative price return during the month of January. As the FOMC continues to hike the fed funds rate throughout 2018, the short-end of the yield curve will likely respond in-kind. Additionally, we believe further out on the yield curve Treasury bonds will also see a similar rise coming from higher expectations for growth and inflation. The bottom line is rising rates will provide greater competition for higher yielding equities as the year progresses. S&P 500 leadership, up until early February’s market misstep, had been encouraging, as proceeds from the sell-off in bond proxies were deployed into a combination of economically-sensitive sectors and secular growth names. Historically a strong January for stocks portends above-average returns over the remainder of the year; however, as the first few trading days in February have shown, the market could be entering into choppier, if not murkier waters ahead.

We are monitoring the CBOE Volatility Index, or VIX, as it ascended rapidly over the first few trading days of February to around 50, prior to settling back around the mid-30’s at the time of this writing. The VIX spent the majority of 2017 anchored around historically low levels below 10, and closed out January around 13.5 before a parabolic move higher to begin February. With the VIX being the center of the recent sell-off in equities due to the unwinding of short volatility trades, it’s difficult to extrapolate much from the recent spike. The VIX has some shortcomings, but it shouldn’t be ignored as a rising VIX highlights, among other things, greater demand for hedges against falling equity prices from traders and investors. After spending last year in a regime of uncharacteristically low equity market volatility, we appear to be on the precipice of a more “normal” environment for volatility.

We remain optimistic over the balance of 2018 as consumer and small business confidence remains high, and tax reform appears poised to buoy capital spending and dividend hikes, along with mergers and acquisitions activity. We see much to like, but trees don’t grow to the sky and equities can only rise so far without a reset or give back of sorts – how much of a give back is the question. Strategas notes that in the six prior instances since 1950 in which the S&P 500 generated a 7%+ return during the month of January, the average intra-year drawdown for the Index over the balance of the year was over 13%. In those six instances, no calendar year experienced a drawdown of less than 7%.

Source: Bloomberg, Factset, Strategas Research Partners

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