It appears clear that volatility has returned to the market in 2018, something that had been absurdly absent in 2017. The maxim that stocks take the stairs up and the elevator down held true considering it took 5 trading days to wipe out the best January in 20 years. The chart of the 10-year Treasury looks like the view from the base camp in the Himalaya’s with the addition of a quick 50 basis points to the 10-year yield in the first 23 trading days of the year. The VIX is hitting levels that we haven’t seen since the Taper Tantrum back in 2013.
There were eight 1% moves in the S&P 500, in all of 2017: 4 up and 4 down. We have had 6 so far in 2018 and they happened in a stretch of ten trading days. Prior to this recent pullback, the S&P 500 was up 38% since the November 4, 2016 low without as much as a 3% pullback at any point during that run. The market was a persistently placid place, until it wasn’t. So what does normal volatility look like? For more of a historical perspective, the S&P 500 since 1932 has corrected 5%, on average, every 7 months and corrected 10%, on average, every 26 months.
What happened to wake up the volatility Gods?
First and foremost we were long overdue. The S&P 500 had set a record for the number of trading days without back-to-back 1% declines, at 404, and had spent 108 trading days above its 50 Day Moving Average. Investors Intelligence had a 16 week stretch with Bulls reading of above 60 prints, the longest time frame on record. Long overdue for some type of action.
Markets had gotten stretched by most measures. The S&P 500 was up 20% in 2017. We saw a 12% parabolic move from November 2017 to January 26 2018 as excitement over the passage of a Tax Bill kicked in a fear of missing out mindset. Exiting 2018 the S&P 500 was trading at about 23 x earnings. At the same time market is in the midst of one of the best rounds of corporate earnings upgrades for S&P 500 companies on record. In sum, estimates for 2018 profits have increased by more than $10 a share since mid-December, a pace four times faster than any stretch seen since at least 2012. If you measure using those estimates, valuations don’t look as lofty — factor in 2018 estimates and stocks trade at a multiple of 16.8. If you extend to 2019 forecasts, the price-earnings ratio comes down to a healthy 15.9.
Bond Yields and Inflation
One of the triggers for the recent selloff can be found in a rapid rise in yields, coinciding with some hints of inflation. The January jobs report showed a surprising uptick in average hourly earnings, up 2.9% and revised up from 2.5% to 2.7% in December. One data point does not a trend make. Nonetheless, this report started an abrupt narrative shift ranging from 4 Fed rates hikes in 2018 to significant drag on profit margins and resetting equity price premiums. While the 50 basis point back up in 10-year yields in a short time frame look extreme, and disruptive, they are actually not all that uncommon. Looking at monthly moves in the 10-year treasury over the past 30 years, we observe absolute month-over-month moves greater than 30 basis points more than 25% of the time. The 10-year yield jumped 13% in January 2018. Historically the 10-year yield has seen moves greater than 10% about once every eight months. It has been painful, but it does happen.
Crowded Short Volatility trade
It is also evident that one of the more popular and perhaps crowded trades heading into 2018 was short volatility/ long equities. That trade can be can be expressed in a variety of ways, and was very profitable in 2017. As volatility spiked, it became apparent that the exit of this trade was narrow and disruptive, adding significantly more pressure to falling equities. The jury is still out on how much of the unwind of this position has occurred.