What began as a normal correction related to a quicker than expected increase in market interest rates (the 10 year Treasury rose from 2.5% to 2.8%) accelerated on Monday afternoon due to trading related to volatility strategies. These strategies helped the market on the upside over the past year but are largely unrelated to economic and corporate fundamentals. While extreme downside market volatility can impact the economy as consumers and businesses lose confidence and hunker down their spending, Northlake sees current economic fundamentals in good shape and disconnected from the market downside over the past few days. There is a lot of money invested in these complex strategies that needs to be unwound. This is leading to further downside this morning and the days ahead are hard to predict.
Our strategy always looks at crisis periods first through the lens of whether it will impact the economy and corporate earnings and lead to a recession. Our second viewpoint is the impact on the valuation we place on economic activity and earnings. We do not presently see an economic or earnings problem. The extreme volatility could impact the multiple paid for earnings as investors are reminded of risk after a prolonged period where it was ignored. The bottom line is for the very short-term we are going to sit tight because we see investment fundamentals in good shape – economic growth, corporate earnings growth, corporate cash flows are all in good shape and poised to strengthen in 2018.
Below is a good explanation of what happened on Monday afternoon. Most clients won’t understand what JP Morgan’s Technical Market strategist is talking about. That is actually the point. The trading is disconnected from economic fundamentals that drive long-term value and that is why we think the best course of action is to stay the course.
In last week’s note, we noted that volatility, at the time, was not sufficient to trigger systematic strategy de-risking. On Friday, the market dropped ~2% on a day when bonds were down ~40bps. The move on Friday was helped by market makers’ hedging of option positions (as gamma positions turned from long to short midday). Friday’s move, on its own, was significant as it pushed realized volatility higher, which is a signal for many volatility targeting strategies to de-risk. Anecdotally, broad knowledge about the risk of systematic selling kept many investors fearful and waiting on the sidelines (both in equity and volatility markets). Midday today, short-term momentum turned negative (1M S&P 500 price return), resulting in selling from trend-following strategies. Further outflows resulted from index option gamma hedging, covering of short volatility trades, and volatility targeting strategies. These technical flows, in the absence of fundamental buyers, resulted in a flash crash at ~3:10pm today. At one point, the Dow was down more than 6%, and later partially recovered. After-hours, the VIX reached 38 and futures more than doubled—it is not clear at this point how this will reflect on various short volatility products (e.g., some volatility ETPs traded down over 50% after hours). Today’s large increase of market volatility will clearly contribute to further outflows from systematic strategies in the days ahead (volatility targeting, risk parity, CTAs, short volatility).