If this last crazy week in the market seemed to come out of nowhere, you haven’t been paying attention.
Not to play the blame game or anything. We’re all guilty of it to some extent, and none of us could call the exact timing.
We’ve just been lulled into an unprecedented sense of complacency. I think it will persist after this week too.
We’re just a handful of months from the longest bull run in U.S. history. The indices have roughly doubled since March 2009.
Plus this month saw a level of volatility that was so low, the market was primed for big moves.
So let’s take a moment for a bit of perspective on what happened this week, without more than a sentence or two talking about the Fed or data.
Then, without falling back on the tired but true ‘buying opportunity’ line, let’s look at how there is a silver lining to all of this most people never notice.
A quick and easy weekend read, let’s get started.
You Call This Volatility?
Here is what the CBOE volatility Index looked like this week. It isn’t pretty, with a peak over 50% higher on Tuesday from the close on Thursday.
The thing is, we’re coming off of volatility so low that there are only three times since the VIX started tracking volatility through short-term options that the index was low — March 2013, June 2014, and July 2014.
Here is a look at a logarithmic full chart. As you can see, outside of somewhat regular spikes, the average VIX value has trended down, even from the wildly bullish years following the crash.
This is the perspective we need to keep in mind. This week was barely a blip on the radar. We just all got so used to a sideways market with virtually no trading volume.
Then, when the indices shaved off a couple points, it happened really fast. There was no churn to soak up the selling pressure.
We just saw a slew of positive and negative economic data, which is basically par for the course. The only thing that matters is the Fed.
Even though a 0.25% interest rate move isn’t much, we can expect this week to repeat itself in December too, probably with another big lull in between.
Don’t assume that we’re back to the status quo when the VIX is down to the levels we saw last week. A natural reversion to the mean involves levels we’ve seen this week, hopefully with fewer wild swings.
On the Brighter Side
Now for the silver lining to this rodeo-like market.
Uncertainty wreaks havoc on discipline and nerves, but shaking up the market like this tends to break down broad market correlations.
Kind of like how a you need to kick a tire rim nice and hard to break up the rust that is keeping it fused on and preventing a fix.
Here is a quick look at sector correlations from the beginning of the year to Wednesday, and from the beginning of September to Wednesday.
The closer the number is to one, the more it trades in line with the S&P 500 ETF, which is a decent proxy for the market.
As you can see, earlier this year, when the markets broke down, correlation was lower across the board, especially for some of the best performing sectors, like utilities (XTU), long-term government bonds (TLT), and gold (GDX).
In a healthy market, correlations across asset classes and sectors are typically low.
When correlation across asset classes increase, indiscriminate selling is rampant as investors move into cash.
We could be looking at a correction that extends into next week as well. Elevated correlations are exactly what we are seeing still, even for the sectors that are doing well.
The correlation for all these instruments has markedly increased. Anyone can figure out what the implications of blind across-the-board selling means for equities and bonds alike.
It very well might mean short-term pain across the board, but shaking it all loose now is very advantageous in the long run.
That bodes really well for the sectors that were performing well before they got fused onto the broader market. Especially gold.
