Was This Week A 'Healthy' Pullback? Doesn't Seem Like It.

With low rates and a grinding higher, low volatility environment like we saw in 2017, it was easy for investors and fund managers to get complacent. This was especially true after the exuberance in January where everything was up without any rotation in the market. Retail investing in stocks jumped as their attention turned from fledgling Bitcoin to the seemingly easy money in stocks. The low volatility trade became crowded like never before.

What could go wrong? We had foreseeable growing global growth (which usually leads to higher global rates and global synchronized tightening). We had a stock market that was called a runaway freight train in January, leading Goldman Sachs to claim risk appetite was at its highest level on record. The Fed made it clear it is raising rates, but the dollar remained weak…? Our concern a week ago was what impact higher long-term rates would have on the passive investment crowd.

Suddenly we get a spike in volatility along with higher long-term rates, VA (variable annuity) and asset allocation accounts have to hedge using equity index futures, and we have a de-risking environment on our hands. It was the perfect storm as forced de-levering in vol-based strategies hit all at once. Volatility is turning up from a 50-year low.

The pace of the bond market sell-off started raising concerns about its impact on equities. But, it’s more about the passive investment story as the bond and equities become more correlated. This becomes a concern to risk parity funds and balanced mutual funds. Rick Santelli and Bob Parks had a nice piece that explained risk parity and volatility control. The reason it’s a concern is that negative correlation dampens the volatility in bond/equity portfolio and higher correlation increases it. Here you can see the correlation between the S&P 500 and the PIS.

This is the first chart I look at every day. The PIS (passive investment strategy) using the long bond and E-Mini S&P futures. We had our eye on this all last year, along with TLT+SPY and TY+ES, and I highlighted it in last week’s post. On January 26th and 29th it was testing the top of the trend channel and our thought was to look for a pullback of some sort. 

Easy money for such an extended period of time had to end (badly), but some are calling this a healthy pullback? For some this hasn’t been that healthy at all.

According to Michael Schmanske, formerly of Barclays where he oversaw volatility products, “The problem with your XIV and the other levereds is they’re always daily resetting, and there's always the potential that they can blow up on you,” he said, noting that the XIV imploded “not because it necessarily is a bad trading vehicle, but because the internal algorithm for it dictated that it needed to be stopped out.”

The fact that this happened overnight when retail accounts couldn’t react is concerning.

30-year bond futures have now broken the 200-week moving average which has been very pivotal support.

We still have plenty of room in long TLT+SPY before it would test the long-term trend line from the 2009, financial crisis low. That trend line is another -9.5% lower.

Keep your eyes on ETF flows to see if retail investors are pulling out. According to this Bloomberg article, the largest ETF in the world (SPY) just had it biggest four-day outflow on record. We haven’t seen anything like this since 2007. SPY is holding below its 50dma and is currently down -10.5% from its January high. Everyone has their eyes on the 200-day moving average as pivotal support, but what can we expect from here? Let’s look at a couple other crisis and see what we might expect.

Two other instances of rapid and sharp declines in SPX; the August 2015 China currency devalue and the 2010 Flash Crash. On Aug. 11, 2015, the People’s Bank of China (PBOC) surprised markets with three consecutive devaluations of the renminbi, knocking over 3% off its value. The Flash Crash of 2010 saw a trillion dollars of value disappear in half an hour. It bounced back quickly but raised the question of whether or not trading rules failed to keep up with the markets.
The flash crash was supposedly due to a fat finger type event, but showed market vulnerability to electronic execution and raised the question whether or not trading ruled failed to keep up with the markets. The current Short-Vol Crisis is just another example of complacent markets being vulnerable. Back in October 2017 Zerohedge posted an article A Reminder: Gross Vega On VIX ETFs Just Hit A "Staggering" All Time High.

The key takeaways on the outlook for next week: look for choppy, two-sided trade and the lows may not be in just yet… the Fed’s not worried.

David Wienke is the editor of Keystone Charts. More than 30 years of experience providing technical analysis and execution services to institutional clients is now provided in a daily newsletter, The Daily Game Plan. Coverage includes equities, rates, currencies, and commodities. Dave is also an introducing broker with Capital Trading Group, LLLP (CTG); a Chicago based investment firm focusing on alternative investment opportunities for CTAs and individual investors. Charts are created using CQG, the best charting service there is. For a free trial of the Daily Game Plan newsletter go to www.keystonecharts.net , email me at dave@keystonecharts.net or go to Capital Trading Group to subscribe

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