Volatility Gets Back in the Saddle Again

Key Points

  • Volatility spike caused the market’s price drop; not the other way around.

  • Have we successfully gone from a FOMO to a LIFO market environment?

  • Sentiment and valuation excesses have corrected along with the market; but complacency should be kept in check.

We went from panic buying to panic selling in less than two weeks. What’s worth pondering is whether we have effectively moved from FOMO to LIFO. For those of you neither text slang nor accounting lingo inclined, that means we may have gone from a “fear of missing out” era to “last in, first out” era … in a very short span of time.

We may have also experienced a classic LTFC market. “Let’s test the new Fed Chair” has been a remarkably consistent tendency by markets, and clearly Jerome Powell is no exception, with last week being his first week on the job.

Were stocks simply overdue for a correction?

The short answer is yes, but it’s never as simple as that. We had traveled the longest span in S&P 500 history without either a 3% or a 5% pullback; and it had been two years since the last full 10% correction. But corrections don’t tend to come out of the blue, and there were a number of factors which had been troubling us over the past couple of quarters.

As we noted late last summer when we moved U.S. equities down from an overweight to a neutral, valuations were stretched and investor sentiment was beginning to show heightened levels of optimism—a contrarian indicator at extremes. That sentiment excess kicked into an even higher gear as the market closed out 2017 and roared into the first month of 2018.

I wrote about the anatomy of a melt-up in a December 2017 report; and that it represented a “risk” for the market in that they tend to end in melt-downs. So some of what we saw over the past couple of weeks may have been the melt-down that corrected much of the sentiment excess. The correction’s onset had its fundamental roots in heightened inflation expectations, the upside breakout in longer-term Treasury yields, and expected tighter monetary policy. But there were important technical underpinnings to last week’s action in particular.

Short vol trade implodes

I had the cartoon below created by our wonderful graphics artist Charlos Gary last November for my use at Schwab’s IMPACT conference. Clearly at least a couple of these “bubbles” have either burst (short vol) or had a heck of a lot of hot air let out of them (Bitcoin and complacency).