Market Note – September 2, 2015

Sometimes when one says that things “aren’t going well,” it is a polite way of suggesting that certain events are causing real trouble.  Last week’s market movements are well beyond the description that things didn’t go well – they were a disaster.

To keep the statistics brief – since you can’t have missed them – the Dow and the S&P both entered correction territory for the first time in four years.  Defined as losing 10% of their value from the high, the last leg was shaved off in the matter in a few minutes on the morning of Monday, August 24th.  Though there was a partial recovery by Thursday, the ferocity of the movement down is not to be ignored.

Spikes in the VIX 

A couple of the events we saw last week give me real concern.  First, the VIX, an indicator of the implied price of insurance on stocks, shot from the 20s to the 50s in the matter of an hour on Monday.  That index has sat in the teens for most of the past two years, and rarely edged into the 20s.  The last time it shot above 50 was 2008, when stocks proceeded to lose half their value.

In many respects, the VIX was responding to the present events and lost its usual forward-looking insights.  Specifically, the spot VIX was in the 50s while the forward VIX (contracts on the VIX that trade in future months) was still hovering in the low 20s, a relatively calm level given the market dislocation.  The most important point here is the magnitude of the movement in the spot VIX, and the fact that it hasn’t moved in this way since October 2008, shortly after Lehman collapsed and just before a vicious round of declines that finally brought the market to its knees in March 2009. The difference between now and then is the stability of the domestic economy, although don’t underestimate the power of volatility in driving down market values.

Chart 1 – VIX from 2007 to 2015

During the past eight years, the VIX has surged on three prior occasions – the Great Recession, the Flash Crash and the U.S. Debt Downgrade.  Last week’s movement pushed again to those same surge levels, surpassed only by 2008.

Source:  Bloomberg

Pressure on Liquidity in ETFs

The second worry is the trading we saw in Exchange Traded Funds.  Since 2008, the ETF market has exploded, accounting for an increasingly significant amount of daily trading and assets held in retail accounts.  On Monday, the ETF market simply froze.  Trades that did execute were 30% away from their index value in some cases.  A large and growing sector of the stock and bond markets does not have the liquidity necessary to support timely exits for investors.

The statistics on ETFs are impressive – to date there are 1,400 ETFs, with the largest one, SPY, capitalized at $130 billion.  That would put it as the 33rd largest company in the U.S.  In total, ETFs represent $2 trillion in assets invested in the U.S., a substantial portion of total investments held in accounts.  The challenge with this security type is the way that they are created and dissolved.  In short, only certain trading firms are allowed to create a block of ETF shares by buying the underlying securities in the market and issuing the new ETF shares.  The process is reversed when there is a large demand for ETF share redemptions, with the potential to “force” large selling of the underlying shares.  With an ETF based on a large and liquid market, this is not usually a problem, but in the smaller ETF markets that are exploding, this creates extreme market stresses at exactly the wrong time – when the underlying shares are already stressed by a down market.

The ramifications have yet to be fully seen, but as we saw in the Flash Crash of 2010, it can significantly distort the market and effectively block the exit doors during a fire.  Thus far, the disruptions are temporary – lasting just a few hours – but the impact on market psychology is not yet understood.  More importantly, we don’t know what knock-on effects this might create in markets that are experiencing other unrelated issues.  In the case of a black swan event, this could be a factor driving the market to even further over-correction.

There are a dozen or so other data points that I could discuss, but the conclusion remains the same – the market radically changed its composure on Monday.  Going forward, we can’t expect to see the same sort of market behavior that we came to adore for the past four years.

Underlying Economic Conditions

The difference with this correction is that there is little new information in the market, and what we do know about the economy remains positive. The market itself was largely flat for the entire year – hitting a new high in May but failing to push beyond that high for some time.  That said, the lows have been extremely muted as well, with movement between this year’s low and high of just 7%, a narrow trading range that we haven’t seen in decades, if ever.

Meanwhile, the underlying economic conditions are in fact fairly promising.  Jobs in the U.S. are growing steadily and the housing market is heating up again after eight years.  Europe also has seen some signs of relief from its recession, with the Greek debt crisis behind them and growth starting to engage in many regions.  The data coming out in September, however, will be critical to the direction of the markets in the short term.  Any hint of a disturbance in the U.S. economy – real or inferred – will cause significant gyrations.  Combined with the continued uncertainty around the Fed’s interest rate policy, and you have situation that can lead to further volatility continuing through the fall.

While there may be hints of real trouble lurking in news of manufacturing data in the U.S. or China, the majority of material generated by the financial media is purely noise.  The devaluation of the currency two weeks ago leads people to now assume that the Chinese economy is on the skids.  I strongly disagree with this sentiment, pointing out that China is still experiencing extraordinary growth whether it be the 5% annual GDP growth that is likely or the 7% that they target.  Keep in mind that 5% growth in China is in dollar terms almost equal to the dollar growth of Europe and the U.S. combined.  China is growing – it is just a matter of how much and how that impacts demand in the rest of the world.

Conclusion

We will delve into the demand characteristics of Chinese growth and the other market issues in our quarterly Market Update, but for today the discussion is market volatility.  Whatever the cause – and eventually we will find out – the likelihood is that the massive swings are not over.  Volatility creates fear, and fear creates losses as investors head for the exits. We are unlikely to return to market highs until this current round of volatility and fear is purged from the market psychology.  As I mentioned, we are seeing events happen that have not occurred since the last market collapse in 2008.

As always, please feel free to call or write with questions or concerns regarding your account.  Our investment philosophy is geared towards capital preservation in volatile markets.  We will continue to exercise this prudence, while looking for opportunities in the current market environment.

Regards,

David B. Matias

Managing Principal