Dear Valued Clients and Friends –
I spent a significant portion of the last 48 hours looking deeper into the nature of the market sell-off we experienced Wednesday and Thursday of this week. Friday’s rebound notwithstanding, it was a particularly destabilizing week, made more so by the lack of real explanation or catalyst. By Thursday I was finding the explanation that investors were merely prepping for a new round of inflation expectations (and therefore higher interest rates) wholly unsatisfactory. For one thing, that expectation of meaningfully higher inflation is balderdash (not the word I wanted to use). Secondly, I see no evidence anyone really believes it, and as fate would have it, the money was flowing from risk assets like equities to Treasury bonds (pushing yields down, not up). In other words, it was a classic risk-off decline, not a new paradigm of higher inflation/interest rates driving this. Allow me to unpack all this more …
- I believe more and more it was a story of the dollar’s rise specifically against the Yuan. Note, I did not say “the dollar’s rise” as a sort of general global currency appreciation, because in fact, it declined last week against the Euro and many other currencies. I am specifically talking about the Yuan.
- The Yuan has not been over 7 to the dollar in over ten years. The currency depreciation taking place in China (partially if not largely to fend off the impact of the trade tariffs) is not, in and of itself, economically destabilizing. However, it most certainly can become so, and can indicate/point to economic instability, if it is followed by large capital outflows. This happened in August of 2015 and January of 2016 and global markets absolutely threw up until things stabilized.
- A huge part of me believes that the talk of China being labeled a currency manipulator is creating an undertone of market instability, in so much as it could weaken global growth to some degree at a time when global growth is not in any mood for complication.
- And I would not ignore the Italian debt fiasco, either. The spread over bonds blew back out over 3%, meaning things are hardly well across the pond.
- The huge part of the market driven by momentum factors flipped to the short side, or at least to the sell side, and an extraordinary unwinding of leveraged trades began. The report I read indicates that it was not merely quantitative hedge funds and CTA’s selling, but directional hedge funds as well (who certainly had leverage on their positions).
- All of this leads me to believe that there is fear of global conditions hitting U.S. markets, and that if the fears around China and Europe prove warranted, it may paradoxically end up with more money coming into U.S. markets.
- So is it the ten-year yield we have to watch to guess where the market is going next? Hardly. A rising bond yield offers this kind of predictive value:
*Strategas Research, Investment Strategy Report, Oct. 12, 2018, p. 2
- I have several colleagues that are quick to point out that right as this sell-off was cascading, about 90% of the S&P 500 was in a “blackout” period from buying back their own stock, as they are within the window of their own earnings announcements. The chart here verifies this is true, but I have to say, if this was a real contributing factor, that cannot be taken as a positive (that the market would now be so dependent on company buybacks).
*Strategas Research, Investment Strategy Report, Oct. 12, 2018, p. 4
- The violence of the sell-off was likely accelerated by “technical” factors like leveraged trade unwinds, ETF order books, and CTA/risk parity trades. But the directional sell-off cannot be blamed on such.
- Buyers to offset the selling pressure may have been limited by the lack of company treasurers in the marketplace buying back their own stock, but that cannot be considered a primary factor, and if it were, we have an unhealthy market that relies so heavily on such.
- International/global conditions may very well be what breaks the Fed’s resolve in their 2018 hawkishness, but we do not know that.
- We are happy with our present asset allocations, grateful for our alternative investment performance, and convinced that our defensive bias in equity portfolios has been and will continue to be the right thing for our clients.
- China’s capital controls are worth watching. Again, the key is what capital flows indicate about their economy, not what they do to their economy.
- This immediate period of extreme market swings is stupid. It doesn’t point to reality. Good investment policy is never found in extreme activity.
- Finally, FUNDAMENTALS WIN IN THE END. Unfortunately, I have yet to devise or find an investment strategy where I can divorce all investments of fundamental strength from peripheral noise that ought not be having such an effect.
I discussed this market week with Charles Payne on Varney & Co. on Friday.
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group is registered with HighTower Securities, LLC, member FINRA and SIPC, and with HighTower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through HighTower Securities, LLC; advisory services are offered through HighTower Advisors, LLC.
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