To say U.S. stocks hit a rough patch in the fourth quarter of 2018 is no exaggeration. From October to late December, the S&P 500 and the Dow Jones were both down roughly 20%. The Nasdaq was down closer to 23% before all three indexes started to recover from their lows.
We are not accustomed to this level of volatility despite what happened in the first quarter of 2018. Volatility, as measured by the VIX, was higher in December than it was at any point in the previous three years with the exception of one week in early February. This is a very brief recap of the end of 2018 and next we’ll explore possible causes of the market turbulence.
Of course, we can’t say with certainty exactly what affects markets as there are far too many independent moving pieces. But these moving pieces make it so interesting to try and puzzle out. There are, however, three possible catalysts, considered by many, as most likely responsible for the volatility: The government shutdown, Commodity Trading Advisors (CTAs), and the Federal Reserve.
Government Shutdown – The government shutdown is vast and troubling. You cannot turn on the news without seeing finger pointing and blame gaming. It’s disturbing for sure, but given the timing, it doesn’t fit as a catalyst since stocks peaked in early October. So, we’ll ignore the shutdown at this time and let you enjoy or tolerate its omnipresence in the news as you see fit.
Commodity Trading Advisors (CTAs) – The state of the government shutdown leaves CTAs as another likely culprit being blamed in the financial circuits. The vast majority of CTAs are nothing more than momentum following “actively” managed futures funds. We use quotes around the word actively because their rules for investment decisions are based on extrapolating into the future the current trend in perpetuity. A mentor once said, “The shortest distance between two mistakes is a straight line” to warn against exactly this behavior. A reason these strategies fit the bill, as partially to blame for the historically bad December we just had, is there is a meaningful amount of capital controlled by these algorithms and they all make decisions at the same time due to their similar rules. That’s why we tend to believe the fitting explanation for why the selling was so extreme the week before Christmas – the CTAs were forced by the chart to flip from being long stocks to full short. And, by the time their selling stampede was over, the market bottomed and went on to have its best ten day run in 50 years because the panic sellers had already panicked. We would say they didn’t cause the volatility, but they helped make it rougher.
Federal Reserve – Since around 2011 the Fed has been engaging in a Quantitative Easing (QE) program where they buy bonds, treasuries, and mortgages in the open market to manipulate interest rates at their desired points on the yield curve. Stocks have loved this plan and been only too happy to run higher for years. The Fed is now engaged in the opposite of QE, which is Quantitative Tightening (QT). Rather than actively selling bonds into the market, the Fed is not rolling its bonds forward as they mature. But whoever issued the debt still needs to roll it forward so this action will have a very similar net effect on the market. The Fed’s balance sheet was due to start shrinking right about the beginning of 2019. And, not coincidentally, the stock market bottomed when Fed Chair Jerome Powell back peddled his comments about being hard set on the rate of QT. When he said he was willing to listen to markets and data, the markets loved this statement and rallied.
One of the legendary stock market aphorisms is, “Don’t fight the Fed.” Whether the Fed is on the right path for how they go about QT or interest rate increases/cuts is irrelevant. What is relevant is they’re doing it. The trick now is figuring out how this is going to play out since Mr. Powell, if he is truthfully planning to adjust his QT plans based, in part, on the stock market, just handcuffed himself into a big Catch 22. If he says he’s going to continue QT, stocks tumble forcing him to say he’s going to pause QT. When he says he’s going to pause QT, stocks rise. If they rise enough, he will give the all clear to put QT back on. It’s a terrible feedback loop creating more volatility and slaughtering the aforementioned CTAs. Those strategies of pure momentum following are almost guaranteed to both sell and buy at exactly the wrong times during the sort of volatility we would expect to see if Mr. Powell does find his QT plans a slave to the market.
If Mr. Powell stands strong and doesn’t fall to the markets, that means QT continues as planned despite the screams from the market commentators and the market itself. In summary, we believe the Fed’s actions may be the cause of the volatility of the fourth quarter, the CTAs exacerbated the situation, and the government shutdown is a flashy distraction without too much direct impact on stocks. It also likely means domestic stocks could be in for a bit longer of a bumpy ride. On the bright side, this situation means capital will be flowing elsewhere. As for now, Acumen will maintain our quality bias, diversified portfolios, and equity allocations at the lower end of their target allocations.
Happy New Year!
Wesley Flatt, CFA® and the Acumen Portfolio Management Committee
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