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WEEK AHEAD
August 5 -9, 2024
Despite last week’s volatility, which was not unexpected, Sowell’s technical indicators softened due to the negative market momentum. Nevertheless, the models continue to support a fully invested position for the time being.
From the Sowell CIO Desk
It is not 1987 yet. Part of the recent increased volatility is a function of the market's past behavior. The S&P 500's P/E ratio rose above long-term averages, and the market's impressive rise in the immediate past has been driven by a concentration of very few stocks. There is little room for market sentiment to disappoint. Unfortunately, recent economic data have provided some overreaction to disappointments.
Today's market open is due to contagion fears with the Japanese market suffering its worst daily decline since 1987 when it fell 12.4% overnight today. This decline followed the decline in US markets from last Friday. The futures markets indicate the Dow, and the S & P 500 will open today with substantial declines. This trend began on Friday with the release of data showing weak job growth and an increase in unemployment to 4.3%. These new data points helped raise heightened concerns about the US experiencing a recession.
While there are some signs the economy might be entering a period of "slow growth," only a serious miscalculation in the formulation of economic policies would bring on a decline in real growth. The current short-term slowdown is a direct result of the Fed's operating hypothesis that the only way to reduce inflation is to reduce economic growth. This hypothesis is wrong, and it is the same one that drove the monetary policy of the 1970s, which produced low economic growth and rising inflation, a set of conditions the Fed thought could not exist.
The Fed has indicated it will lower the Fed funds rate sometime this year. The market has seized on that policy change as it develops an expectation for resuming real economic growth of about 2% at an annual rate. The change in policy needed to reduce the probability of a recession is an increase in liquidity. The Fed needs to move to a policy of quantitative easing.
Some market participants naturally draw parallels with the October 19, 1987, one-day market collapse. The Dow fell more than 22%, and the S&P 500 dropped more than 20% on that Monday following a roughly 4.5% decline on the previous Friday. Prior to the collapse in prices on the 19th, the stock market had risen by more than 40% over a period of about seven months. Current circumstances are similar but also very different.
In 1987, the economic environment included lowered tax rates and reduced regulations. Currently, tax rates are about to rise as the current tax schedule sunsets and regulations are increasing. In addition, the Fed is now faced with difficult choices which will limit its policy options. The CBO estimates the deficit for 2024 will be $1.9 trillion. If the Fed monetizes that debt as it has for the last 53 years, the economic environment will include slow economic growth and possibly rising inflation. The policy most likely to produce a favorable economic environment would consist of a steady growth rate of the money supply consistent with a 2% to 3% inflation rate.
In 1987, the recovery from the steep decline was rapid; on an annual basis, the market produced a positive return for all of 1987. Whether or not the current decline continues and a recession develops will depend on the Fed's policies and the results of the November election.
Speculating on Fed policy and the outcome of elections is not the usual foundation for formulating sound investment policies. Nervousness is to be expected, but panic seems unwarranted.
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The stock market, at times, can feel like an emotional rollercoaster. As the market awaited Chairman Powell's highly expected decision to keep rates unchanged, the S&P 500 index gained 1.58% on Wednesday. But like the harmonic motion of a pendulum, the S&P 500 index fell the following two days, triggered by earnings concerns, a pull-back in the AI momentum, and unemployment rising to 4.3%. As a pendulum does, with a positive displacement, there's an equal negative displacement. From positive expectations of a highly anticipated cut in interest rates, the pendulum swung to the opposing side, overreacting to fears of a recession due to job weakness. To dampen the emotional rollercoaster with the influence of the Fed, aka gravity, let us remind ourselves, as the Fed has stated all along, that its monetary policy actions are guided by a dual mandate to promote maximum employment and stable prices. 4.3% unemployment is still well beyond the maximum unemployment levels and about where they stood on the eve of the pandemic. Scrutinizing earnings valuations and slowing economic growth is the objective of the Fed's interest rate decision to curb inflation. But let us also not forget that the Fed is better positioned to respond to the risks and uncertainties where interest rates reside today than in pre-2020, during a largely zero interest rate environment since the Great Recession.
Despite the rocky start to August, the S&P 500 index and Nasdaq Composite are still sitting in positive territory with a YTD gain of +13% and +12.2%, respectively. The pendulum's momentum for bonds also swung to positive territory as market forces pushed the 10-year yield to fall by 40 bps for the time being.
Looking ahead, volatility will likely remain the name of the game as earnings season unfolds, revealing the economy's underlying strength through reports from industrial giants like Caterpillar, consumer staples such as Tyson Foods, and healthcare leaders like Amgen and Eli Lilly. Bond yields are expected to fluctuate as investors continue to speculate on the Fed's next move dissipates, despite the central bank's efforts at transparency.
"I'll give an example of cases in which it would be appropriate to cut and maybe that it wouldn't be appropriate to cut. So, if we were to see, for example, inflation moving down quickly, or more or less in line with expectations, growth remains let's say reasonably strong and the labor market remains consistent with its current condition, then I would think that a rate cut could be on the table at the September meeting. If inflation were to prove sticky and we were to see higher readings from inflation, disappointing readings, we would weigh that along with the other things. I think it's going to be not just any one thing, it's going to be the inflation data, it's going to be the employment data, it's going to be the balance of risks as we see it, it's going to be the totality of all of that, that would help us make this decision."
— Chair Powell's FOMC Press Conference, July 31, 2024
The VIX is surging
Well-known fear gauge on the rise
Throughout the first half of 2024, there's been plenty of uncertainty around Fed policy, elections happening around the world, and geopolitical tensions in Europe and the Middle East—you name it. But what we haven't seen nearly as much of is the typical manifestation of that uncertainty in financial markets: volatility. In recent weeks, though, that looks like it could be changing. Last Wednesday, the CBOE's option-implied measure of market turbulence, the so-called 'VIX,' spiked by 3.3 points, its biggest daily jump since March 2023. In the last two weeks, the VIX is 32% higher.
Volatility low relative to past levels
Of course, it's all relative, and things look different if one compares these recent moves with a longer history for the VIX. Even though investors' perceived stress has been way up over the past couple of weeks, it's still low historically. Indeed, when plotted against over two decades of readings on the VIX (see chart), it's clear the recent flashes of volatility are still way below levels seen in past episodes of increased market choppiness.
Indeed, one might have imagined a narrowly failed assassination attempt on a former US president during a campaign rally—one of the events precipitating this recent bout of volatility—putting markets a bit more on edge. Back in April, a combination of fears over escalating Middle East conflict and interest rate uncertainty caused a slightly bigger spike in the VIX. Still, even that mini-peak to around 19.2 was short of its long-run historical average of 19.5.
Technical factors to blame?
Experts have pointed to a number of things that might be artificially suppressing the VIX, which is based on the prices of publicly traded stock options. The increased popularity of zero days to expiry ('0DTE') options by speculative traders seeking outsized leverage, for example, might have sapped volume away from the one-month options on which the VIX is based. A recent paper by researchers at the Bank of International Settlements suggested its demand for covered call writing strategies, the hedging of which mechanically dampens volatility.
Anxieties around Q2 earnings
Regardless of what might be leading the VIX toward a lower average against a fraught macro and geopolitical backdrop, investors ought to take notice when it jerks higher as it has in recent weeks. One source of turbulence we're closely watching is larger-than-usual moves in individual stock prices after reporting quarterly results. Extraordinarily high expectations this earnings season and some notable releases have led to big declines: Tesla's miss, for example, or Alphabet's Q2 beat paired, unfortunately, with disappointing guidance.
Volatility creates tactical opportunities
We've added some risk in our models as US economic conditions seem to bring us closer to inevitable rate cuts—maybe not in September, but hopefully by year-end—though we haven't been shy about pointing out elevated valuations for some stocks in the face of a range of real threats: from downside surprises on the macro front to continued geopolitical instability likely to be exacerbated in an election year. For tactical investors seeking to put capital to work, trends in volatility suggest to us there may be some interesting opportunities ahead.
Election Volatility
Politics helping boost the VIX?
In our remarks above, we made more than one mention of politics, and there's been no lack of uncertainty in the political domain since late June. After President Biden's terrible performance in a late-June debate against then-opponent and former President Donald Trump, we discussed what a second Trump term might look like for investors. A lot has happened since then, and it's especially interesting to discuss in the context of the VIX. Below, we share some interesting research from Bank of America, directly connecting volatility to US presidential elections.
Researchers on Bank of America's equity quant team calculated monthly average volatility over the last 24 election cycles and looked at how market stress fared over the typical timeline entering a race's home stretch. It turns out volatility historically increases from July to November in an election year, falling back down to earth in December after polling uncertainty shakes out and the path forward is clearer. If that pattern holds, we might expect the VIX to trend up over the next few months on our way to the polls later this year.
Harris' ascension doesn't surprise us
As for the so-called 'Trump trade,' how have things changed in the days since our last election-related dispatch? We couldn't have imagined there would be an attempt on the former president's life—though we might have expected his lead over Biden to improve in the wake of the failed assassination. Our commentary did tip Biden's likely exit from the race and his replacement by current VP Kamala Harris, who seems to have locked up the nomination more or less.
Trump still the one to beat in November
Judging by prediction market probabilities, Harris has marginally improved the Dems' chances of winning in November, though Trump is still a favorite for re-election. As of last month, the GOP was pegged at over 54% probability of taking back the White House. In this sense, things we thought might happen in the case of a Trump victory, like a steeper yield curve, a weaker dollar, and outperformance of stocks sensitive to regulation—think health care and financials—become just a shade less likely. One thing we imagine becomes more likely: that increase in volatility we just described.
Candidates likely to keep traders on edge
Markets got a taste of that policy-induced volatility just about two weeks ago when Trump opined to Bloomberg Businessweek that he blamed Taiwanese chip manufacturers for decimating America's semiconductor industry and suggested Taiwan should be paying the US for military protection. Along with concern over bans on selling semiconductors and chipmaking equipment to China, such news was enough to send the S&P Global Semiconductor Index sliding by over 9% that week. We don't expect that to be the last time US candidates will roil markets in the coming months.
Footnote: Reprinted and revised with permission from Rayliant Investment Research in partnership with Affinity Investment Advisors. The following article was originally published on July 29, 2024.
Advisory services offered through Sowell Management, a Registered Investment Advisor. The views expressed represent the opinion of Sowell Management. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and non-proprietary sources that have not been independently verified for accuracy or completeness. While Sowell Management believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Sowell Management’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. Investing in securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results.