The Market Corner: The Month in Review "Already gone?"
By Filippo Lecchini
Already gone?
On Feb 8th the S&P500 officially closed down 10.2% from the all-time high of 2,872.87 recorded on Jan 26th. Fast forward a month though and we are at the same levels of mid-January 2018. Just over a month has gone by since the selloff and the celebrated return of volatility, and all we are left with is even more questions.
Is this how corrections are going to look like going forward? Broad statements are hard to make, but it’s possibly true people tend to relay mostly on the past when forming expectations. Economies and markets evolve over time. Nowadays, we are not as concerned with oil dependency due to alternatives and production has changed in ways that an abrupt spike in oil prices would not have the same ripples as it did in the seventies. And that’s one reason why inflation is taking such a long time to make it back into public discourse.
Another aspect is technology; are situations developing and resolving faster in an algo dominated market? It sure seems that all these moves up and down have been pretty quick and violent with some noticeable changes of direction intraday not seen since the financial crisis.
How about fundamentals? The economy is in good shape, growth numbers are getting better, unemployment is down to what economists consider the natural rate, and earnings remain good. And yet many predict more corrections. Those who fear the FED believe that a strong economy will cause the new Chairman to move faster and increase rates four times instead of three but is that really bad? Arguably it’s not the FED’s goal to kill growth, quite the opposite, economies are used to growing in higher rate environments anyway. By historical comparison rates remain very low and is dubious that small and gradual hikes would ruin the party for everyone. Traditionally, the financial markets like to see commitment to keeping inflation in check and really 6% rates are nowhere in sight.
A different question, more behavioral in nature, is why people take risk the way they do if they believe that dark clouds are gathering on the horizon. There are different types of risk of course, buying funds in the 401k or individual stocks for example are reasonable regardless on the environment. Timing the markets is a fool’s errand for most of us and those decisions should be based on long term and fundamentals anyway. The so called short volatility trade is entirely different and comes in various shapes and forms. This term is used very loosely, and different people mean different things ranging from dumping options premium to pricing implied volatility versus historical volatility in hedged positions (volatility arbitrage), or using exotic products that under a familiar appearance, an ETF for example, hide a complex and leveraged structure. Bundling all these together seems incorrect as the level of sophistication of strategies and traders varies dramatically, but the ultimate question is what notion of expected value supports taking the catastrophic risk that some did. I can think of two answers, at least.
Some people do not take the expected value at all and most likely those are the types who mistakenly interpret favorable outcomes for skill. Once something happens, it will be too late for them to change their mind. The other group, which might include incredibly smart and sophisticated people, is the one that relays heavily on a model that eventually turns out to be wrong. There are all kinds of research on optimal decision under uncertainty but one approach is less known and might be worth a minute of everyone’s time.
Fractal geometry, popularized by the French mathematician Benoit Mandelbrot, is an attempt at explaining the unpredictable and large moves that the models based on standard assumptions and the normal distribution do not consider as likely outcomes. The fractals model rather than making a number of smoothing assumptions is built on gaps and frictions that are more widely utilized in natural sciences. A similar argument, that does not require an extensive math toolbox, is the Theory of Black Swan Events aimed at removing the sense of false security that extended periods of quiet and well behaved markets can easily induce.
No matter one’s point of view on all the above, the markets, and the economy, February’s action reminded everybody that we only know so much. The financial markets offer opportunities for reward because there is always risk transferring, whether it’s immediately apparent or not.
Looking ahead:
NAFTA talks are ongoing while the topics of tariffs and international trade are taking center stage. The FOMC meets on March 20-21 and that could kick off another round of hikes. After predictably inconclusive elections, Italy is trying to find a new Government like Germany has. In the US, policy remains fluid as some jobs in the Administration are being reshuffled.
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