Thursday 19 September 2019

Panic now and avoid rush later as market tectonic plates are finally on move


Can markets recover and return to new highs later in the year? Maybe so, they have managed to do so many times before but I would not be counting on it
Can markets recover and return to new highs later in the year? Maybe so, they have managed to do so many times before but I would not be counting on it

Paul Sommerville

It was only a month ago I penned a column warning investors they needed to prepare imminently for volatility. It has arrived with a vengeance.

"We have gone from fear to enthusiasm to greed and are now clearly in the delusional phase. The lack of volatility is lulling investors into a preposterous sense of complacency," I wrote.

Last year was the quietest in history in financial market terms. It will go down as the most peaceful year in stocks, with 95pc of all trading days having an intraday range of less than 1pc. Not just in stock markets but in all asset classes. Equity and fixed income volatility in 2017 reached the lowest levels ever.

The VIX or the Volatility index (also known as 'investor fear gauge') is the most widely-known and quoted gauge. VIX is the ticker symbol for the Chicago Board options exchange Volatility Index, which shows the market's expectation of 30-day volatility.

Before 2017, a close below 10 in the VIX was an extremely rare event. It had only occurred a handful of times since 1990, nine to be exact. In 2017, closes below 10 were frequent. From January to November 2017, there were 79 days when the VIX got below 10 at some point during the trading session, including 44 days when it closed below 10. Eighteen of 20 all-time lowest VIX closes ever occurred in 2017. The others were two consecutive days, December 22-23 in 1993 - just before the Christmas holidays.

So 2017 was extraordinary. We expect 2018 to be remarkable, but for different reasons - and investors need to prepare. All the price action last week, while explosive, needs to be taken in context of 2017. The price instability has been exceptional but it is an inevitable and predictable reaction to 2017. The elastic band stretched and stretched and finally there was a backlash.

Volatility this low and this smooth for this long is a gigantic flashing warning signal but one that most investors fail to see or appreciate. That complacency is now being punished.

The Dow Jones, after falling over 500 points the previous Friday, fell 1175 points last Monday. The biggest one-day points fall in history. Do not forget, however, we are falling from a great height so it is nowhere near a record in percentage terms at 4pc. That record goes to the crash of 1987, where the market fell 22pc in one day. However it may be instructive to know just before 'Black Monday' in 1987 the Dow had rallied 43pc year to date to October. The Dow is up 40pc since US president Donald Trump was elected.

An official 'correction' is considered a fall of 10pc and the Dow has already managed it with the other USA indices not far behind.

The S&P500 went 94 days without a +/-1pc change and then had six in the last nine days. The S&P 500's longest run in history without a 5pc pullback ended on Monday after 404 trading days.

The VIX traded above 50pc on Monday. During the LTCM/Asia crisis, the dotcom burst or the financial crisis of 2008/09 it never got above 50. But it did this week.

Volatility funds which have been 'picking up pennies in front of the steamroller' for years were well and truly run over. Billions lost in a matter of hours. Some funds shuttered. If you had invested in the XIV, the well-known Credit Suisse 'short volatility' fund you lost 96pc of your investment in one day.

Of much more importance was the selling pressure, after subsiding in the middle of the week, reasserted itself with even more venom last Thursday. The weak bounce pummelled; the 'buy on the dip' crowd crushed. The Dow fell over one thousand points. This is highly significant.

The hysteria and absurdity of human nature is captured eloquently in many of the sentiment indicators that were flashing red before this week. The USA retail investor turned up just in time. The American Association of Individual Investors'(AAII) asset-allocation poll showed at end of 2017 members' exposure to stocks were as heavy as it was near the 2000 peak and their cash allocation was at the lowest level since December 1999. These retail investors are allocating 72pc of their portfolios to stocks, just 13pc to cash. The last time we saw similar readings the S+P 500 fell 51pc in the next 30 months, the NASDAQ fell 78pc.

We now have a younger generation of traders and investors who have no memory of volatility or drawdowns.

Why this week? There are two reasons for this sell-off. One is simply the bond yields in the USA are rising and traded through a "tipping point" last week. That has scared the equity market. Bond yields are signalling that the era of deflation or low inflation has passed and a new higher inflationary environment is upon us. Secondly, at the same time, the central banks that have hooked the patient on to the crack cocaine of quantitative easing have signalled their intention to reduce and then stop the supply. The market is forward pricing mechanism so it does not wait until these things occur but price in the future eventuality, today. In short, we are transitioning to a new environment of higher inflation and quantitative tightening (QT).

Every analyst and TV pundit rushed to the screens Tuesday to declare it is nothing to worry about. News stories that feature the phrase 'buy the dip' surged to a new record, according to a Bloomberg analysis.

I would disagree with that analysis. The market is signally clearly that the investment environment is changing. I would suggest this is a similar warning sign as Northern Rock in 2007. Nearly every analyst argued that it was an isolated incident (we did not). It was a tremor or foreshock, the earthquake was 18 months later.

If you hold investments you need to be examining them now and cutting or reallocating to other areas. There are still plenty of interesting areas to invest and this volatility also brings opportunities. However in my view USA markets are likely to have more shocks similar to this week. I do not see last week as an isolated event, rather a warning.

In our note to subscribers two weeks ago called 'If Carlsberg did market tops, this is what it would look like', we noted "valuation, sentiment and momentum indicators all point to an historic top in equity markets".

Can markets recover and return to new highs later in the year? Maybe so, they have managed to do so many times before but I would not be counting on it.

Regardless, the message from the markets is clear and unequivocal. The tectonic plates of world markets are finally changing after an incredible dormant period. Investors who fail to see the significance of this week may live to regret it.

We would suggest investors should "Panic now, avoid the rush later".

Paul Sommerville is CEO and head of Advisory of SAM. He can be contacted at

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