Stocks: Beware the Ides of - February?
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
© Regions Bank, Member FDIC. This publication has been prepared by the staff Regions Asset Management for distribution to, among others, Regions Wealth Management clients. Regions Asset Management is a business group within Regions Bank that provides investment management services to customers of Regions Bank. The information and material contained herein is provided solely for general information purposes. This material is not intended to be investment advice nor is this information intended as an offer or solicitation for the purchase or sale of any security or other financial instrument. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only current as of the stated date of their issue. Certain sections of this publication contain forward-looking statements that are based on the reasonable expectations, estimates, projections and assumptions of the authors, but forward-looking statements are not guarantees of future performance and involve risks and uncertainties, which are difficult to predict. Investment ideas and strategies presented may not be suitable for all investors. No responsibility or liability is assumed by Regions Bank, its parent company, its subsidiaries or its affiliates for any loss that may directly or indirectly result from use of information, commentary or opinions in this publication by you or any other person. The content and any portion of this newsletter is for personal use only and may not be reprinted, sold or redistributed without the written consent of Regions Bank. Regions, the Regions logo and other Regions marks are trademarks of Regions Bank. The names and marks of other companies or their services or products may be the trademarks of their owners and are used only to identify such companies or their services or products and not to indicate endorsement or sponsorship of Regions or its services or products.
Employees of Regions Asset Management may have positions in securities or their derivatives that may be mentioned in this report or in their personal accounts. Additionally, affiliated companies may hold positions in the mentioned companies in their portfolios or strategies. The companies mentioned specifically are sample companies, noted for illustrative purposes only. The mention of the companies should not be construed as a recommendation to buy, hold or sell positions in your investment portfolio.
Neither Regions Bank nor Regions Asset Management (collectively, “Regions”) are registered municipal advisors nor provide advice to municipal entities or obligated persons with respect to municipal financial products or the issuance of municipal securities (including regarding the structure, timing, terms and similar matters concerning municipal financial products or municipal securities issuances) or engage in the solicitation of municipal entities or obligated persons for such services. With respect to this presentation and any other information, materials or communications provided by Regions, (a) Regions is not recommending an action to any municipal entity or obligated person, (b) Regions is not acting as an advisor to any municipal entity or obligated person and does not owe a fiduciary duty pursuant to Section 15B of the Securities Exchange Act of 1934 to any municipal entity or obligated person with respect to such presentation, information, materials or communications, (c) Regions is acting for its own interests, and (d) you should discuss this presentation and any such other information, materials or communications with any and all internal and external advisors and experts that you deem appropriate before acting on this presentation or any such other information, materials or communications.