Wednesday, February 14, 2018

The correction is here. What next?

In our last post we mentioned how the 3 major US equity indices all broke their steep rising trend-line from the January lows.  In turn, we expected volatility to pick up.  Well that was certainly an understatement.  Volatility went ballistic and the equity markets had the long overdue intermediate correction that so many investors have been waiting for.  What seemed to spook most traders was the speed and violence of the correction.  The S&P had a close to 12% correction from peak to through in just 10 trading days from all time highs in January.  While the velocity of the pullback was shocking to most there is precedence as history shows.   The flash crash in May of 2010 had a 2-week decline of 12.5% straight off highs.  Going back to the 1950's the current 2-week loss ranks only 49th, while most of the bigger losses were during bear markets there were plenty during bull phases.  During the bull market in the late 90's 1996, 1997 and 98 had similar 2 week plunges off highs.  The recent move has been compared to the 1987 crash but there was a more analogous move in September of 1986.  The question we are pondering: is this an intermediate correction within an ongoing bull market or the start of a prolonged correction/bear market?   Ultimately we don't know the answer.  However, we use all the data we monitor and make an educated bet.  If we are wrong in our market call we utilize risk management to keep losses to a minimum.


Below if we look at breadth in the form of % of stocks trading above the 50 day moving average we can see that during the current correction, breadth has hit extreme levels associated with prior drops.  The good news is when you get a wash out in breadth, historically you are closer to finding a low.  Did the market find a low last Friday or are we subject to a retest?  Again we don't know the answer to that question.  Urban Carmel over at the Fat Pitch Blog tried to answer this question in his latest post.  In our own experience, after you get a quick trend reversing move, it typically takes a few weeks for the ultimate low to be established.  What we are looking for is the potential for a positive divergence setting up as the market tries to stabilize after the current shock.  This will take shape in breadth improving as price probes lows.  Our best guess is the general market will need more time to digest the violent pullback we just experienced.

Below are some stats on corrections and bear markets to keep the current move in perspective.  According to Goldman Sachs the average bull market correction is 13% over four months an takes just four months to recover versus and average decline of 30% during bear markets.

One of best ways to get a read on the macro environment and sentiment is the monthly fund manager survey from BAML.  Below are the key takeaways from the February report.
  • Close but no Buy the Dip from FMS: BofAML Feb FMS cash & portfolio de-risking show anxiety, but most FMS metrics indicate “pain trade” remains lower asset prices driven by stronger US$, hawkish central banks, and slowing global growth.
  • Bulls not Bears: FMS sentiment nudges BofAML Bull & Bear Indicator down from 8.5 to 8.4, i.e. remains in “sell” territory, suggesting likely test of recent market lows.
  • Asset allocators blinked: FMS cash level up to 4.7% from 4.4%, record 20ppt jump in protection-buying and a steep 12ppt drop in equity allocation...note FMS history shows monthly 16ppt drop in allocation required to signal a risk asset rout complete.
  • Bonds crash the party: 60% say Inflation & bonds most likely catalyst for cross-asset crash (#2 was US/EU corporate bonds @15%), bond allocations cut to lowest since 1998, REIT exposure cut to 6-year low; top 3 “crowded trades”...#1 long FAANG/BAT, #2 short US$, #3 short volatility; strong US$ & lower yields would be painful.
  • Thinning macro ice: 91% say recession “unlikely” & FMS investors remain long cyclicals (tech, banks, energy, EM, EU, Japan); defensives continue to be shunned despite 70% say “late-cycle” (highest in 10 years); ebbing BofAML FMS Macro Indicator indicates global stock price levels still high.
  • BTD, FOMO, TINA dependent on EPS: FMS investors most bullish on profits since 2011, strong EPS most likely positive risk for stocks, and confirm cyclical outperformance to date; interest rate catalyst slowly reversing, leaving EPS as lone driver for risk assets.
  • Best contrarian trade: long Utilities, short Banks (68% hit ratio when FMS bank-utilitysentiment this stretched).
One of the main culprits of the recent market weakness was the blow up of the short volatility trade.  This is just another reason why we prefer tactical exposure and practice active risk management.  Below is the chart of the XIV etf.  It lost more than 90% of its value overnight as they bet on volatility remaining quiet.  This strategy posted remarkable returns over the last few years until it was all over in 1 day on the heels of the VIX having its biggest one day move ever.  As of last months survey this was the most crowded trade and caught many funds holding the bag.  FMS cash rose to 4.7% moving the FMS cash rule back into a contrarian "buy" signal.  My guess is this number will increase next month also.  Meanwhile there was a big rotation into cash in February as investors were reducing risk.  Outside of volatility, the biggest tail risk remains inflation and a bond crash.  The move in yields has the attention of most traders and one of the bigger reasons this market remains on edge.   The current allocations confirms the jitters as cash climbed to net 38% overweight which is the highest since Nov of 2016.  At the same time, allocation to bonds is now at a record low net 69% underweight and equities fell to 43% overweight which is the largest one month fall since Feb of 2016.  On a positive note investor expectations for above-trend growth and above-trend inflation hit their highest since April 2011, overtaking below-trend growth and below-trend inflation for the first time in seven years.   

In summary, the market got a 5 and 10% correction all in the span of 10 days after breaking records for the longest streak without such pullbacks.  Based on our last post the fundamentals remain bullish and the current correction hasn't changed that.  We will be watching yields and how they play out over the next few months but with allocations at all time lows to bonds, we think the contrarian position might be the best play in the short term.  Our thesis on the continuing bull market remains intact and we think pullbacks should be looked at as opportunities instead of panicking.  With that said, from a tactical angle the next few weeks or months could contain bouts of heightened volatility and choppy market action.  We plan to keep some powder dry while taking smaller position sizes looking for opportunities to exploit as the market digests the current action and tries to resume the longer term up trend. 

Ryan Worch is the Managing Director of Worch Capital LLC. Worch Capital LLC is the general partner of a long/short equity strategy that operates with a directional bias and while emphasizing capital preservation at all times.

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