A Correction Built on Volatility

We had been warning of a correction, and we pointed out that the longer it took for the correction to arrive, the more painful the losses were likely to be. The market had endured more than 400 trading sessions without a 5% pullback, and two years without a 10% correction, so it made sense that when the correction finally arrived it would be a doozy. A 12% drop (intra-day) is what we got as the participants ran for the exits. Most didn’t even know why they were running, they just saw others leaving (prices collapsing) so they did too.

All kinds of reasons are put forward to explain the stampede: rising rates, rising inflation (expectations), rising wages, and systematic risk parity strategies (shorting the VIX). In our view, only the latter reason is meaningful, and we’ll explain after we deal with the former three reasons. As far as rising rates are concerned, the Fed has been communicating for months that they are going to reduce their balance sheet and continue raising rates this year (3 more times), therefore, that cannot be why the market suddenly decided to tank. When it comes to inflation, there is very little chance that it will get out of control, especially with the Fed raising rates and quantitatively tightening, so inflation is not the reason for the pullback. What about wage increases as the cause of the stock price collapse? The chart below, shows that the year-over-year wage increases were lower in January than in the prior month. How could this possibly trigger a market collapse? Obviously, it did not.

The real reason for the correction, was programmed shorting of the volatility index (VIX); a systematic risk parity strategy that was incorporated into ETFs and ETPs and then sold to retail investors. It is a complicated game (you can read more here), but the core of the problem is that there was a huge leveraged bet that volatility would stay low (i.e. leveraged short positions on the VIX). As soon as the VIX did something it had not done in a very long time (and which people forgot it could do) — increase — it forced the leveraged short positions to cover (buy) the VIX. The resulting short-squeeze then pushed the index from 17 to over 50 causing a systemic risk-off domino effect across equities. That’s what happened.

As well as warning of a correction, we also made clear our view that the bull market, while being in its later stages, has not come to an end. There is a fire in the casino because a game got too hot, but it doesn’t mean that “Rome is burning”. This is a technical correction, not a fundamental change in the business cycle.


Equities

Sentiment
In response to the pullback, the AAII bull sentiment dropped -7.7% to 37%, while the bear sentiment increased +6.3% to 35%. This is the normal response to a weak market and we expect that sentiment will get more bearish still as the market sorts itself out before starting the next leg up.

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The put-to-call ratio has made a down-spike which confirms the formation of a local top (chart below).

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The PE of the SPX in ratio to the VIX has peaked recently and the SPX has dropped as was expected (chart below).

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Technical
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Fundamentals
The 10-y minus 2-y differential expanded this past week from 0.69 to 0.78 but continues to maintain an overall slope that would see an inversion in the second half of 2018. That would imply a recession could start sometime later in 2019.

Oil

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Gold

Gold failed to make a new high and has dropped back to support at $1310. The technical indicators are now in, or near, over-bought levels which sets up two possibilities for next week: a bounce and second attempt at a new high: or a break of the $1310-$1300 support level and reach down to $1270. It will depend on what the correlated markets do (chart below).

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Forty years of private equity trading, and still learning.