MARKET VISION

Is the Party Ending Soon?

February 22, 2018

We began February with the VIX (volatility index) skyrocketing to 50 (see VIX chart below) from a lower range that was hovering between 10-15 since the end of 2016. The average is closer to 15. The S&P 500 dropped -12% in the first week of this month and we can label this as a true correction. Not the beginning of a recession. I strongly believe that the probability of a recession in the next 12-18 month is still very low. If I was to come up with a number I would say 10-20%. More thoughts on any future recessionary projections later.
The VIX chart below highlights the three largest spikes in the VIX, which includes the 2008 recession, the BREXIT vote, and the latest correction. Now I must also state that the chart clearly shows that the VIX only points to shorter-term volatility in the markets and is not a true predictor of a recession. Although during the period, prior to the 2008 recession, we did have some short-term spikes above 30, but there was a financial crisis that was the real culprit.


But we also see in the chart that the S&P 500 rose from a low of 666 to above 2800 (>300%), before the recent pullback to the 2700 level. So, what we clearly see is that we need a major factor (ex: financial crisis) to incept a recession. You must see economic slowdown prior to a recession. You cannot see a recession in an economy that is still expanding, with strong corporate earnings, backed by a recent catalyst (recent tax cuts). Our economy is very strong, and we see growth in global markets/economies.

 

 

Now the issue we might see in late 2019, or possibly, in 2020, is that if several factors come together we could start to see recessionary pressure. The first thing I would watch is a slowing of corporate earnings or lower earnings growth quarter over quarter. A second factor, is U.S. or global GDP growth slowing. If we have slower GDP growth in the next few years there will be a strong focus on U.S. debt as there were additions to the debt credit card, with the tax cuts, and recent proposals in Washington. The third pressure point is a rise in interest rates at a quicker pace than is expected. This could be worsened with quicker Fed interest rate hikes, if they try to battle any inflationary risk. As we are seeing lately with these wild point swings in the market that are mirrored by any increase or decrease in the 10-year Treasury yield, that is currently at 2.91%. The 10-year is a major indicator for interest rates. As we saw yesterday, the 10-year went over 2.92% and the Dow dropped from a high of +240 points and closed down 150 points. Today we are at 2.91%, again, and the Dow is up +300 points. So, the markets and investors are closely watching any commentary and action that is coming from the Fed. I personally believe we will see the 10-year go over 3% in the next six months, but what typically happens, is that there is an initial negative reaction by the markets, but then the market shows comfort and resiliency and then heads higher. We don’t want to see the 10-year heading to 3.5% or even 4%, very soon.

 

I don’t want to discuss algorithms, too much, in this memo, but they track key indicators like technical markers and the 10-year rate. We might see that being a factor in some of these short-term swings. Just as we saw, during the recent correction, they sold off quickly, and then there was aggressive buying as we crossed the lower 200-day moving average. The algorithms help to exacerbate things. Of course, algorithms are not the only factor with these swings, as you have regular investors trying to time market exits and purchases (big mistake). Also increased passive investing doesn’t help the situation, as the buying or selling affects many stocks at one time versus the trade of one company.
But let me emphasize that the corrections are healthy for the markets. We will continue to see more volatility spikes this year, which will lead to -2%, -5% or -10% corrections. Last year we didn’t have any and the market was up 19%. We will not see 19% this year. Wall street consensus is around a 6% increase (S&P 500) by the end of this year. We believe that 10-12% can be achieved with the right focus on alpha opportunities that can be captured by focusing on individual companies, as we do. Of course, this cannot be guaranteed.
Technical levels


As we mentioned in our 1/11/18 memo, that we saw excessive gains in the market in January and the technical levels should be resetting, which they did. We dropped lower than I expected touching the 200-day moving average (see chart) and we rebounded within the two-year trend lines that we have been tracking. I think the S&P 500 will continue within this two-year trend this year, unless we have some external factor (ex: geopolitical) that we cannot foresee.

 

Conclusion
So, the concerns we are seeing now is that the market wasn’t quite sure the Fed was going to do - what it is supposed to do - which is raise rates. Or possibly the Fed might be behind the curve and will raise maybe four times this year, instead of three. I don’t want think what might happen with five increases. The party began with low rates and wonderful central bank policies and liquidity, that were quite accommodative when needed. Now that rates are increasing a valuation of risk assets is needed, more so to sector and company exposure. We continue to believe that most bonds are negative in a rising rate environment. Some moderate and conservative investors still need bonds, in their portfolio, but must be cautious, as to what types, and be wary of overallocation into one specific type of bond. This tug of war between higher rates and the markets will continue. We will see upward spikes on good economic news. Also, volatility will be more present this year. There will be more corrections, but I don’t expect a significant drop over -20%. We are watching corporate earnings closely. I am hoping that companies will use their extra cash, from tax cuts, to increase salaries or hire more, but I am hesitant to bet on this. We are already seeing record buybacks of company stock. So, we continue to remain bullish, in 2018, but more cautiously optimistic beyond this year.

 

If you have any questions please contact me.


Regards,


John Anagnos
Managing Principal
Chief Investment Officer
AETOLIA CAPITAL LLC
3828 Kennett Pike
Suite 212
Greenville, DE 19807
Office: 302-543-4446
Fax: 302-510-4166
john.anagnos@aetoliacapital.com
www.aetoliacapital.com

 

Disclaimer
Aetolia Capital, LLC (“Aetolia”) is a Registered Investment Advisor ("RIA") registered with and resident of the State of Delaware. Registration as an investment adviser does not imply a certain level of skill or training, and the content of this communication has not been approved or verified by the United States Securities and Exchange Commission or by any state securities authority. Aetolia renders individualized responses to persons in a particular state only after complying with the state's regulatory requirements, or pursuant to an applicable state exemption or exclusion.
This communication is intended to provide general information about Aetolia. It is not intended to offer investment advice, or to offer or recommend the purchase or sale of any securities or investment product. Investment advice will only be given after a client engages our services by executing the appropriate investment services agreement, and shall be subject to the terms and conditions therein. Information regarding investment products and services are provided solely to inform the reader about our investment philosophy, our strategies and to be able to contact us for further information. Please do not forward or replicate without our permission.

 

 

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