19 März 2018, 17:23 GMT
What triggered the move?
The catalyst of the price drop was the high US average hourly earnings (2.9% more than a year ago). It’s a vital statistic because full employment should force wages up which brings more consumer spending. That could be the start of inflation. With only a 4.1% unemployment rate such wage growth is well overdue.
A return of inflation would mean a return to ‘normal’ and by my reckoning that means a 3.25% interest rate, 4% 10 year government bond yield, and a 16 price/earnings ratio of the S&P500 (i.e. higher bond yields and lower equity prices).
But the average hourly earnings statistic was only the catalyst. The bulk of the move was selling by trend followers and other high frequency quant strategies, notably short volatility funds some of which were hit so hard by the jump in volatility that they closed having lost their entire value.
Is there more selling to come?
Volatility, measured on a look back basis, is now higher, and mathematically it must remain high regardless of what happens to markets from here. Risk parity funds have become hugely popular and by my calculations will be selling 15% of equities. I think they’ve only just started that. In fact I suspect they were the cause of the second leg down in equities on February 8. Some only trade at month end, so look out for more volatility at the end of February.
That said, whilst market fundamentals have changed (higher volatility), company fundamentals have not. So value driven investors like me may provide some market support. I note from my conversations last week that there’s no sign of fear from active managers. That makes the market precarious and highly uncertain (in both directions).
What to do?
For what it’s worth, I bought equities on Tuesday, February 6 with my own money. I wrestled with two possible regrets:
1. I buy equities and their price drops again. That would irritate me but not as much as...
2. not buying equities and seeing the price correct back up. We’ve waited a while for a buying opportunity and now one has arrived I’d like to take it.
By Tuesday, February 6, the price drop was no more than a reversal of the January appreciation. It’s dropped further since, yet I’m unemotional about my loss. My behavioural mind-set is still one of satisfaction having been proactive in response to the price action. If other early buyers are like-minded the bottom may not be far from here.
Watching high frequency price action will give us a sense of market participant's sentiment, and thus technical analysis is of higher importance now.
What fundamental developments could affect events from now?
I’ve always felt that wage growth has stayed low, in part, due to a lack of worker confidence in their employment stability. But for the first time since the crisis I’m anecdotally hearing of staff requesting pay rises or leaving their jobs. My feeling is that this is genuine wage growth. But average earnings is an incredibly noisy data series, and our economists are flagging that next month could easily be a lower number especially given the signs that the US is near the end of its economic cycle.
And even if earnings do improve I’m not sure that means more consumerism because debt burdens are so high. I share our inflation experts’ view that inflation will not come through that much. In that case three rate rises may be a struggle for the Fed in 2018 therefore 3% bond yields are attractive to me.
The one person I do have sympathy for is incoming Federal Reserve Chair Jay Powell. If markets don’t stabilise in the next few weeks he’ll have a very challenging first press conference (on March 21 - there is no February meeting): should he even raise rates at all in March even though that was signalled in January? That event plus the upcoming CPI release are key focuses for me. Economic growth metrics are less interesting. For me it’s all about inflation.
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