Volatility is Back
Over the past few weeks, stock prices have wildly fluctuated as volatility returned to the equity markets. This has spurred investors, who believe we are in the early stages of the next great Bull market, to buy during every dip, or drop, in stock prices. Most of these investors don’t understand why volatility is back or why stock prices are suddenly falling after effortlessly rising for the past ten years. Most investors also don’t understand that volatility was always lurking beneath the stock market and the Federal Reserve is the reason volatility has returned and asset prices are suddenly falling.
Volatility is an indication of how much stock prices should fluctuate in the short term. When volatility is low, stock prices tend to make small moves and when volatility is high, stock prices tend to fluctuate wildly. While increased volatility is often associated with falling stock prices, volatility doesn’t predict the direction stock prices will move. There are numerous periods of heightened volatility where stock prices rose. Many modern investment programs are designed to sell stocks as volatility rises, which should cause investors to be concerned with the fact that volatility has returned.
Volatility never left the stock market, as stock prices are inherently volatile by design. Following the Great Financial Crisis of 2008-09, volatility was deliberately suppressed by the Federal Reserve to drive investment dollars into stocks to create a wealth effect. With the Fed removing monetary support from the economy that led to the suppression of volatility, it has actually caused volatility to return to the markets.
To encourage investment dollars to flow back into risk assets, the Fed implemented several rounds of Quantitative Easing (QE). Quantitative Easing is when the Fed purchases government-backed bonds from the banks in exchange for cash. This exchange of money doesn’t directly lead to volatility suppression, but it encourages it.
By pulling Treasury bonds off the market through successive rounds of QE, investors were left with little choice but to buy riskier assets. As more money flowed into riskier stocks, volatility fell. Now the Fed is slowly selling off their Treasury holdings, which is forcing investors to buy bonds. By forcing investors to buy bonds, less money flows into stocks, which leads to higher volatility.
The Fed forces investors to buy U.S. Treasury bonds by choosing not to reinvest their maturing Treasuries into new Treasuries. Large holders of Treasury bonds tend to reinvest their maturing bonds into new Treasury debt. However, the Fed is choosing not to reinvest $30 billion of maturing debt each month. Since all U.S. Treasury debt must be purchased, monies that would normally flow into stocks are being redirected into the purchasing of Treasury bonds.
The Fed didn’t just purchase Treasury bonds, they also purchased two-thirds of all Mortgage-Backed Securities (MBS), or mortgages. As it turns out, mortgages are highly volatile. To the average homeowner with a mortgage, a fixed-rate mortgage is hardly volatile, but to the bank holding the mortgage, it is.
Unlike the Fed’s U.S. Treasury bond holdings which are maturing monthly, the Fed’s MBS portfolio doesn’t start maturing until ten years from now. The Fed is directly selling off $20 billion of their MBS portfolio to the banks each month. Mortgages increase volatility because the banks must hedge against their mortgage portfolio while the Fed doesn’t.
Banks borrow at short-term interest rates and lend at long-term interest rates. As short-term rates rise, so does the profit margin of a bank holding long-term debt. Since banks cannot control short-term interest rates over a thirty-year period that matches most mortgages, they must continuously hedge against their mortgage portfolio. Hedging requires money to be diverted from other sources, such as supporting the stock market, into hedging against volatility and interest rates.
Most investors don’t understand the implications of the Fed’s actions, but they do understand corporate share buybacks. With the passage of the Tax Cuts and Jobs Act of 2017, many corporations have used their 20% tax cut to repurchase their own stock. Share buybacks are mostly done to allow corporate executives to sell their stock back to the corporation who granted them the shares in the first place.
When the Fed is buying bonds and corporations are buying stock, volatility can fall and remain low for extended periods of time. Many investors believe corporate share buybacks alone can bring stock prices up and volatility down, but it may not. During the Great Financial Crisis of 2008-09, corporations continued to buy their stock back at a slower pace than before the recession, and it had no effect on keeping stock prices from crashing.
To add further evidence corporate share buybacks may not be able to boost the markets is found in the numbers; corporations purchased approximately $850 billion of shares back in the first three quarters of 2018. The S&P 500 only marginally set a new all-time high in early October before falling almost 10% by the end of October. The inability of corporate share buybacks to push the stock market significantly higher is a testament to the power of the Federal Reserve’s tighter monetary policy.
Asset prices, including stocks, in a fiat currency system, such as ours, are directly related to the monetary base. The monetary base is the total amount of currency in circulation and the total amount of money held in reserve by commercial banks. Over time the monetary base should expand causing asset prices to rise, which it has. Following the Great Financial Crisis of 2008-09, the Fed used Quantitative Easing to pump the monetary base from about $875 billion in August 2008 to its peak of $4.165 billion in September 2015.
The result of the Fed tightening monetary policy by raising the Federal Funds rate and selling off their bond portfolio is to reduce the monetary base. Since its peak in September 2015, the monetary base has fallen -15% to $3.540 billion. To put the monetary base in perspective, the Vanguard FTSE All-World excluding-United States ETF (symbol: VEU) is down -20% from its cycle peak set back in late January 2018. Foreign stocks are highly correlated with our monetary base, as the U.S. dollar is the reserve currency. This suggests that the S&P 500, which is only down -10% from its all-time highs, is likely to fall as the Fed continues to reduce the monetary base.
While investors remain optimistic that U.S. stocks will continue moving higher for many years to come, the actions of the Federal Reserve are undermining investor optimism. The Fed is planning to remove $50 billion per month from the monetary base, not including any future increases in the Federal Funds rate, which also reduces the monetary base. The growth-rate of the money supply is also decelerating and likely to contract as the Fed tightens, which will also reduce the monetary base. As the Fed continues to tighten monetary policy, volatility will continue to increase, which suggests the likely direction for stock prices is lower, not higher.
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Daily Market Briefs
- Thoughts from the Weekend
The U.S. stock market is facing a critical week as the major indices are heading towards correction territory. Bulls are hoping seasonality comes into play, as stocks tend to rally following midterm elections and into the holiday season. They are also looking forward to corporate share buybacks resuming as the blackout period begins to fade.
While optimism still burns bright in the eyes of the Bulls, they are forgetting about the Fed. As of October, the Federal Reserve has increased their balance sheet unwinding program, or Quantitative Tightening, to its maximum level. The Fed has also been raising the Federal Funds rate with the expectation of another hike in December.
Should the stock market fail to rally next week, it will set up the increased probability of further declines. The seasonal trends may not be strong enough to overcome the Fed’s tightening and a slowing economy. Next week should be interesting.
- What happened to the stock market on Monday?
On what is being billed as a critical week for U.S. stocks, equities lurched in early trading after European equities were up and Asian equities were mostly down. The Fed’s preferred inflation gauge, or Core PCE, showed inflation held at +2.0% for September. Treasury yields faded their early move higher as inflation expectations moderate.
Personal incomes rose +0.2% MoM, under expectations for a +0.4% MoM increase. Personal spending was up +0.4% MoM, below expectations of a +0.5% MoM print as consumers continue to spend beyond their incomes. On a year-over-year basis, both personal income and spending are decelerating. Even the personal savings rate slid to its lowest level since December 2017, validating consumers are dipping into their savings to fuel personal spending.
After starting out they day higher, equities sold off throughout the day and found buyers going into the last 15 minutes of trading. All major equity indices are below their 200-day moving averages as well as their 50-week moving averages. The popular FANG stocks that led the market higher are all down -20% or more from their peak.
Treasury yields were up slightly on the day but faded most of their move higher. When the market turns, Treasury yields tend to rapidly fall. With a near-record short interest underneath, it will be interesting to see all these short-sellers forced to become buyers when they are squeezed out.
Gold miners tagged their 50-day moving average, a positive sign, but faded their gains as the broad equity market sold off. Support for the miners is likely below their 50-DMA, so we will continue to look for support and an opportunity to buy.
Agricultural commodities are in a tight range between buyers are sellers. Once the buyers overcome, prices should move higher.
Today’s move down in equity prices is not a good signal for the bulls.
- What happened to the stock market on Tuesday?
Stocks started out the day surging higher as investors look to “buy the dip” in stocks as the market is flashing “oversold” conditions on a short-term basis. For the past several years buying the dip has been profitable, but right now it isn’t working.
When examining trading volumes, I noticed that as stocks have sold off, investors have been selling other assets to buy stocks. Bonds, commodities and underperforming stocks are all getting sold to buy the big-name stocks. I still believe investors are facing margin calls, and rather than sell, they are buying. When investors are forced to sell their big-name stocks as the monetary base continues to fall, stocks will rapidly fall.
Stock market Bulls are looking to the expiration of the corporate share buyback blackout to boost the equity markets past their recent all-time highs, despite weaker economic data. Experts are indicating $350 billion of shares may be bought before the end of the year, but it may not be enough to boost the markets.
Corporate share buybacks are governed by SEC Rule 10b-18. Rule 10b-18 states that corporations can’t buy more than 25% of their average daily volume, that all shares must be purchased by the same dealer, that depending on the market cap of the company, shares can’t be purchased within the last 10-30 minutes of trading, and that the corporation can’t pay more than the highest independent bid of the last transaction quoted. Simply put, corporate share buybacks alone can’t drive stock prices higher unless other investors are also purchasing.
The total market capitalization of U.S. stocks is approximately $40 trillion. A $350 billion purchase is less than 1% of the total market capitalization. For the S&P 500, which has a market capitalization of $24.58 trillion as of September 2018, $350 billion represents 1.42% of the index. The remaining corporate share buybacks aren’t big enough to make a difference.
Equity bulls are rejoicing after a hard-fought battle today that saw the S&P 500, DJIA and Russell 2000 reclaim yesterday’s drop. Today’s move was more about volatility than stock prices, as volatility was on the cusp of a major move higher like what happened back in February. A repeat of February would send stock prices significantly lower as there is less liquidity in the markets now than earlier this year.
Treasury yields were down a bit on the day as investors continue to sell bonds to buy more stocks. Treasury yields have been tracking oil, which is down from its peak, indicating yields will be the last to drop to end this business cycle. With crude inventories continuing to build, Treasury yields should be moving lower.
Physical gold fell back below its 100-day moving average, while the gold miners tagged and held their 50-day moving average for the second time. Agricultural commodities fought back against sellers to close right on its 100-day moving average for the fourth time. The 100-DMA is acting as support for agricultural commodities.
- What happened to the stock market on Wednesday?
Global stock markets got a boost as U.S. stocks were technically oversold and China is indicating they will stimulate their economy. The last time China stimulated their economy was back in 2016 when they used their foreign currency reserves to pull the global economy up as it was about to enter a recession.
China doesn’t have much in foreign currency reserves, so if they were to stimulate their economy again, it means they will devalue their currency. Such a move is risky since the Trump Administration is ready to apply more tariffs.
South Korean Industrial Production fell -8.4% YoY, the largest drop since 2009. South Korea is has led global economic expansions and contractions, so this is an indication of what is coming for the rest of the world.
Next week the U.S. Treasury will issue $83 billion in debt, setting a new weekly record for debt issuance. Wall Street and investors are saying they want higher yields to buy this debt, but they don’t seem to understand the debt will be sold regardless of yield. Rising government deficits lead to disinflation or lower long-term bond yields.
A simple chart can prove that long-term bond yields fall as a government takes on more debt. I took the inverse of our total Federal debt and charted it against 10-year Treasury yields. With no surprise, after the inflation scare of the 1970’s to early 1980’s, 10-year Treasury yields have fallen as government debt has increased. Based on my chart, 10-year Treasury yields should be under 2%.
Today is the Fed’s SOMA redemption day when they officially unwind part of their balance sheet and destroy money. Typically, SOMA days are bad for stocks, but today was not one of those days as the FAAGN stocks helped boost the broad markets.
Trading volumes were surprisingly light, which is an indication that large investors were not participating in today’s buying spree. Large moves on low volume aren’t viewed as pillars of support. Sure enough, sellers came in an hour before markets closed and slammed the major indices back down. All major indices closed in the green for the day, but hard late-day selling is not an indication of strength.
Treasury yields were up for the fourth day in a row, but buyers have been buying each day. Most of the selling is being done before markets open whereas the buyers are coming in during normal trading hours.
After oscillating above and below its 50-day moving average, the large gold miners managed to close over their 50-DMA. The silver miners are a better proxy of what is to come for the gold miners, as the silver miners have been leading the gold miners. Today the silver miners closed down, just above their 6-month low.
Agricultural commodities saw some hard selling today, but buyers mopped up most of the selling, leaving the ETF down slightly on the day. Buyers continue to show strength here and even foreign investors are buying.
October was an ugly month for global investors as $8 trillion of wealth was lost.
- What happened to the stock market on Thursday?
Experts and analysts are looking to Apple’s after-hours earnings announcement to save the stock market. So far, the earnings from Facebook, Amazon, Netflix, and Google (the other four in the FAANG stocks) have been disappointing. One company can’t hold the stock market up on its own, but Apple’s large weighting in the major indices can help move stock prices higher.
Stocks moved higher after President Trump tweeted talks between China are “moving along nicely” after his brief meeting with President Xi. President Trump may be able to negotiate trade deals, but only Congress can approve them. Since China prefers to negotiate behind the scenes and there are multiple issues beyond trade, this meeting has little meaning. While President Trump’s tweet sent stock prices higher, the bond market didn’t buy it as Treasury yields fell.
The head of Normura’s Quant desk revealed that their CTA’s have increased their equity exposure over the past 48 hours. Even as their computers buy more stocks, the market didn’t retrace much of its recent losses. He also mentioned it appears that there is “forced buying” in the market as large investors have been caught on the wrong side of the recent market movements.
Markit’s Manufacturing PMI increased slightly as the ISM Manufacturing PMI decreased. Export orders are falling, and prices are increasing, indicating manufacturers were front-loading their production ahead of the tariffs. Treasury yields fell following this report.
Unlike yesterday which saw hard selling going into the market close, equity prices held their gains as stocks rallied above yesterday’s closing price. The price action over this past month looks like equities are making a wave pattern down. Elliott Wave Theory suggests that equity prices move in five successive waves. Should this be true, then the equity markets are headed much lower, as we are in wave two of five.
Physical gold and the gold miners moved higher today as the dollar fell. I’m watching the silver miners as I believe they are showing where the buyers and sellers are at, whereas the gold miners appear to be running on emotion. The silver miners are forming a bottom, which suggests today’s move in the gold miners may be quickly undone.
Agricultural commodities lurched higher as buyers overwhelmed the sellers. From a charting perspective, agricultural commodities are forming a nice head-and-shoulders bottom. The breakout line will be covered in Friday’s video, which if broken, should see prices quickly rise.
Apple beat expectations, however, their shares fell after-hours as the number of iPhone units sold were 46.9 million versus expectations of 48.4 million. Fewer units sold means lower demand going forward. The other risk Apple faces with higher priced phones is losing customers to other phone manufacturers. Since Apple generates a sizable amount of revenue from their application store, lower phone sales could lead to lower application revenues.
In the two minutes following Apple’s announcement, the computer algorithms dropped the stock by -5%. In two minutes.
- What happened to the stock market on Friday?
Don’t get too excited about today’s jobs report even as the BLS reported +250k job created last month. What the media didn’t report is that 248k of those jobs were fictional jobs created under the self-employed birth-death model. The actual number of jobs created was 4,000.
Average hourly wages increased 3.1% YoY, sparking concerns of inflation. There are no historical correlations to wage growth and money-printing inflation, so today’s jump in Treasury yields is based on a false premise. If consumers could afford higher interest rates, then housing and automobile sales wouldn’t be decelerating. Nor would the money supply be decelerating.
What is important about today’s payroll report is the Fed will follow the inaccurate headline number and the accurate wage growth number to determine monetary policy. Investors should expect the Fed to raise the Federal Funds rate again in December.
Stocks spent most of their day down but rebounded in late trading as President Trump stated we are working on a deal with China, even though earlier in the day it was confirmed by his staff that there isn’t. With exception of the DJIA, all major indices closed below their 200-day moving averages.
Treasury yields moved higher on inflation fears from October’s wage-growth data and a second time on news of a potential trade deal with China. Wages tend to follow yields higher, not the other way around.
Physical gold traded lower, but the mining stocks moved slightly higher. The summer seasonality didn’t happen, but there is positive sentiment going into the end of the year. Provided this is a bottoming pattern, a move up should be coming soon.
Agricultural commodities also moved higher on the day under heavy volume as buyers overwhelmed sellers. A head-and-shoulders reversal pattern is about to be completed, which should send agricultural commodity prices higher.
Portfolio Shield™ Update –
November’s rebalance went smoothly with minor adjustments to the weightings. The strategy is not hedging, although it has reduced its exposure over the past two months to the more volatile Nasdaq-100 and Russell 2000, in favor of the S&P 500.
As expected, the strategy gave back some of its gains for the year, but it is still outperforming the S&P 500 year-to-date.