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Bull Markets Don't Die of Old Age but Are Killed by Policy Mistakes

02/12/2018 12:00 pm EST


Robert Savage

Partner & CEO, CCTrack Solutions

Rates and policy changes are blamed for the moves in all risk-assets. Whether this is a healthy position washout or the start of a larger problem remains to be seen. Central bankers must decide how they handle turbulence, writes Bob Savage, CEO of Track Research Sunday.

The speed of change matters.  Turbulence follows anything that moves fast whether it’s a plane, boat or a market.

The US S&P500 (SPX) shift from a record high to 10% correction and a test of the 200-day was the fastest in history. The offset to this volatility comes from the size of the actual correction – modest in comparison to the previous four episodes in this bull market. 

The 2011 move down was 19.4% as an example. What really bothers traders this week is causality and correlation. Bull markets don’t die of old age but are killed by policy mistakes. The trust in the technocratic rule of central banks cracks with their talk of moving from extraordinary negative rates and bond buying to something else. The rise in volatility reflects the uncertainty of how this reaction to a global coordinated recovery will play out throughout 2018.

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On one hand, the obsession with liquidity drives the equity market correction.  On the other, the need for a higher risk premium for U.S. debt thanks to its government fiscal policy and to its above trend growth drives the present correction.

The U.S. isn’t alone in the urge for returning to a policy mix where investors have to pay for their returns by taking real risks, but weaning off such may require some harsh lessons.

Rates and policy changes are both being blamed for the moves in all risk-assets over the last two-weeks. Whether this is all a healthy position washout or the start of a larger problem remains to be seen, its up to the pilots – the central bankers – to determine how they handle the economic turbulence that will follow this hit to market confidence.  

Many want to believe this is a simple task because there isn’t any obvious trigger from economic events. However, Buy-the dip no longer sounds sufficient to calm fears, nor will forward guidance about future QE unwinds or rate-hikes sound friendly. 

The new FOMC Chair Powell will have his first test at the end of the month with his congressional testimony. Until then, expect this battle for confidence to be a bit of a bumpy ride.

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Question for the Week Ahead: When does a market correction matter?  The simple answer is when it changes the real economy. There are many factors behind the present failure for the trend – rising interest rates, less bond buying from central bankers, higher fiscal deficits (particularly in the U.S.), more inflation fears, more doubts about global policy (particularly around trade).

The list of reasons why last week happened isn’t convincing – and the lack of obvious economic causality puts many investors on edge – as previous risk-off events were well anticipated and understood – like the Brexit vote or the U.S. election or the French election.  Those events allowed time for investors to get to cash and wait for the storm. The spike to 50% CBOE Volatility Index (VIX) and the collapse of the inverse levered VIX ETN market was a technical part of the week and underscored the persistent problems of structure in a market now expecting central bank intervention and support.  

There is some issue with a market that has replaced old with new models, old traders with new algos, as the regime shift from low yields, low volatility to “normal” begets illiquidity and discontinuity.

The problem with expecting a central bank reaction function (i.e. more easy money) starts with the idiosyncratic pain trade in equities vs. the rest of the asset classes – only when volatility in fixed income, forex and commodities become unbearable will you see a more coordinated global response.

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This move in global shares since January 2 has been fast and without a clear cause.  As a consequence, the buy-the-dip mentality for equities died last week.

Some may find solace in the bounce of the S&P 500 off its 200-day moving average Friday and the better close, but others will say this was all technical and machine made – leaving people still more fearful than greedy.  

While many experts and older investors welcome last week’s price action as a “correction” for a market overbought and overvalued, there are other issues to consider before returning to risk. 

The focus last week was on equities, but the damage done was far reaching across asset classes from the oil uptrend ending to the U.S. dollar (USD/EUR) downtrend reversing. 

Emerging Markets suffered considerably. The IFF reported that investors have withdrawn about $4 billion from emerging markets since January 30. The majority of those outflows came from South Korea, Indonesia and Thailand. The point being that trends and asset class correlations aren’t performing like they did in the past five years – and that change in markets really matters. This isn’t about growth or rate differentials but something else.

The pain of February becomes clear when looking at the SocGen CTA index (a collection of trend following fund returns) and at the Salient Risk Parity index (a proxy for the popular asset allocation process used by many pensions and famously pushed by Bridgewater and AQR.) 

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When the models that worked well for 3-5-10 years fail, then there will be a wholesale revaluation of all markets, not just equities, and that turbulence could be significant enough to upset the real economy.  Only when bonds reach a yield significant enough to offset the urge for returning to equity risks will there be a cushion for policy beyond QE and forward guidance again.

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