After a tumultuous 4th quarter that saw a nearly 20% drop in the equity markets by Christmas Eve, a funny thing happened in Q1. Boredom. The CBOE Volatility Index (the ‘VIX’) is a measure of volatility, but it’s also known as the market’s ‘fear gauge’ – when things get crazy in the markets you’ll see that reflected in the VIX. Here’s a chart of the VIX across Q4 and Q1:
You can see the steep ascent of Q4 and big spike in the middle of the picture at Christmas Eve. Starting the day after Christmas, the market volatility waned, and emerged into February and March as…just plain boring. How rare is that type of shift? What caused it?
The Market I looked at 90 years of market history, 1,096 months to be exact. December 2018 ranked as the 27th-worst month, while January was the 68th-best. Top and bottom decile moves, back-to-back, something commonly seen only in severe bear markets (Great Depression, Crash of 1987, and the Great Financial Crisis also fill out the top decile). A rare event indeed. It was as if the market was sensitive to certain news… The Fed During the 4th quarter, and most of the last two years, the Fed was clear in its intent and language. They were going to continue a path of monetary tightening. Their actions backed up the words; they raised the Fed Funds rate consistently for over two years, taking it from 0.5% in October 2016 to 2.5% by December 2018. In their December meeting minutes, the Fed doubled-down on their previous stance:
“The Committee judges that some further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term.”
Translation: the economy is great, everyone has a job, and inflation is minimal, so we’re raising rates. Remember, the Fed has a ‘dual mandate’ – maintain full employment levels and price stability (control inflation/deflation). It is literally their job to use interest rates to help keep these two measures in a comfortable range. As we wrote here, their actions have been mostly by the book for an economy in the late stages. In their January meeting, everything seemed to change. Chairman Jerome Powell said:
“The case for raising rates has weakened somewhat. We believe we can best support the economy by being patient and evaluating the outlook before making any future adjustment to policy.”
The markets had already begun a tentative comeback from oversold conditions, but the flip in tone and intent from the Fed in late January was all the market needed to continue the ‘V-shaped’ recovery, and by March it was near its September all-time high. Interest Rates Meanwhile…something interesting is happening with interest rates. As we discussed in our last note, interest rates also had a stark pivot point late in 2018, seen here in a graph of the 10-year treasury yield:
This is notable by itself as a clear shift in trend, but what do you notice when we add the S&P 500 to the same chart?
The market mostly matches the rise, then subsequent 4th quarter fall, of interest rates. But something strange has happened in Q1: as the market rebounded, interest rates have continued to fall. This type of ‘jaws’ formation in a chart always gets attention. Two assets, apparently moving together in lockstep, suddenly diverge. Typically, this sort of thing resolves itself, or I should say, the market will do the resolving. Will the market fall to match rates? Or will rates start to rise to match the market? Stay tuned… Continuing on an interest rate theme, here’s a chart of the average 30-year mortgage:
Once again we see the shift in November and the trend now moving the other direction. It certainly looked like higher mortgage rates throughout 2018 were going to crimp the real estate market, but rates have since fallen off, giving continued life to a strong real estate market. Finally, I want to close today by highlighting another significant market divergence, that of Value stocks vs. Growth stocks:
You’re looking at the last 5 years’ performance of Value vs. Growth and the yawning gap between them. Many factors can contribute to this type of divergence, but most people would point to a common sense explanation: Growth companies probably had more earnings growth than Value companies, therefore the better performance. While that may be true, that relationship should not hold forever because of simple market math… Take a classic market valuation metric, Price/Earnings, commonly referred to as the ‘P/E ratio.’ Math tells us that with each increase in the numerator (price), the denominator (earnings) must rise to match, or the ratio goes higher. Over short-time periods the metric is mostly meaningless, but when you have out-performance over 5 years like you see above, it creates an almost impossible earnings growth hurdle for Growth companies to meet, and P/E ratios go up. Thus, valuations begin to look much more expensive (you’re now paying more for a dollar of earnings than 5 years ago). Eventually, you end up with a list of Growth companies with much higher valuations (using our simple P/E example) compared to Value companies, and that difference can lead investors to close the gap, whether it’s selling the now ‘expensive’ Growth companies for gains, or buying the now ‘cheap’ Value companies as the next source of returns.
Summary Q1 saw a lot of the same: a strong real estate market, a strong employment market, and a growing economy. The market returned to low volatility and a steady rise that was present for much of 2017 and most of 2018. Some important changes are happening though, and they’re worth a look. The Fed has now changed its tune, and for now rate hikes are off the table. Interest rates have clearly established a new trend, and they have diverged significantly from the equity markets. The Growth vs. Value gap is reaching levels we haven’t seen in decades. There’s little reason to suspect a bad economy, or shift in market dynamics, in the short-term, both have proven to be very resilient. But I think any market observer will admit that ‘late stage’ indicators are going off in many corners, and it’s worth shining a light there to see if you’re prepared.