Market Musings (15 Dec 2023): Everything Rally

 

·        Monumental week for all asset classes as Fed confirms pivot to rate cuts

·        Broad rallies across the board in equities, fixed income, currencies, precious metals and cryptocurrencies, setting up for a December to remember as 2023 comes to a close

·       Amid a likely melt-up in US equities into year-end, there are signs of protection-buying

Equities

US equities rallied to fresh YTD highs as the Fed confirmed its pivot to rate cuts. Major indices come within striking distance of their 2021 all-time highs, with the S&P500 and NASDAQ100 just 2% and 1% below their prior zeniths respectively. Small caps were the biggest winners with the Russell 2000 index surging 5.5% on the week (up over 3% on FOMC day itself). Littered with unprofitable names often saddled with debt, the affirmation of rate cuts were undoubtedly a welcome reprieve for battered small caps this year. The surge was likely exacerbated by generally poor liquidity in many names and dealer delta hedging-related buying from a large jump in call options open interest on the index.

Over in Asia, the surging Japanese yen took its toll on Japanese equities (well-known inverse relationship between the yen and Japanese stocks) as the TOPIX lagged US counterparts to end the week only marginally higher. Hong Kong shares fared better, helped by an 800bn yuan liquidity injection from the People’s Bank of China (PBoC) on Friday, the largest on record, which helped markets glance over weak retail sales data released the same day. Mainland Chinese shares however were not uplifted by this (temporary) shot in the arm, closing the week down 1.7% at a fresh YTD low.

Cryptocurrencies

BTC and ETH steadied after the FOMC decision on Wednesday, following a wave of liquidations triggered by a sudden plunge on Monday. This did not derail the general bullish momentum across the asset class however, as several Layer-1 coins (SOL, AVAX, ADA) touched new YTD highs on Friday. It is evident that retail interest is returning to the cryptocurrency market, and it is probably only a matter of time before crypto makes headlines in mainstream media once again (hopefully for the right reasons this time).

Although only a local anecdote, one may noticed the increasing number of posts on reddit forum r/sgcrypto, which was largely devoid of activity for much of this year. A simple search on Google trends for “bitcoin” shows a gradual uptick in interest since September. While not certainly fodder for a bullish crypto thesis (always too many of these anyway), it does suggest that the space is not (yet) mired in a speculative fever pitch despite the recent run-ups in crypto prices, as was the case in 2021, and we are not in a “bubble” thus far.

Commodities

Gold mostly took cue from interest rates and the US dollar, regaining the $2000 level post-FOMC after testing resistance-turned-support at $1980 earlier in the week. Palladium was the highlight, surging over 20% on concerns over UK government sanctions targeting Russian metals. Although palladium was not targeted, the news prompted concerns over supply disruptions and was sufficient catalyst for a short squeeze in the metal, which has been mired in a deep bear market this year on weak demand from auto manufacturers.

Elsewhere in commodities, bullish bets on a squeeze in uranium that peaked in popularity during the meme stock mania of 2021 are now paying off handsomely after spot uranium prices hit the highest since 2007. Uranium prices have been on a bull run this year, fanned by rising US-Russia geopolitical tensions frequently spurring concerns of a US import ban on Russian uranium.

Spot FX

Tracking USD interest rates lower, the USD sank after the Fed’s dovish pivot on Wednesday, in a resumption of the weak-dollar theme since late-Oct. The Norwegian Krone was by far the biggest winner this week after Norges Bank (Norway’s central bank) surprised markets by unexpectedly hiking interest rates by 0.25% a day after the pivotal FOMC decision on Wednesday, ostensibly in direct defiance of the increasingly dovish stance taking hold across major central banks.

Volatility

The quarterly “triple witching” took place on Friday as single stock options, equity index futures and equity index futures all expired at once. The day saw an estimated $1.3 trillion delta notional (~$5.4tn notional) expire, most of which likely cancels out. While options dealer positioning after this week is still likely long gamma, thus continuing to dampen market moves in both directions, this sizable expiry should “loosen up” US equity markets to make larger moves in the weeks ahead.

Current narratives contemplate the possibility of a “spot up, vol up” market dynamic in which US equities continue to rally but implied volatility (IV) instead picks up rather than comes lower (opposite of what IV usually does in a rally). This would suggest the current rally could be on its last legs and needs a pause or consolidation phase.

Indeed, there are some signs of protection-buying creeping back into markets after the euphoric rally since late-Oct. The SDEX Index (measuring the relative cost of out-of-the-money options to in-the-money options, or skew) shows signs of a short-term bottom after declining sharply over the last 2 months. Indeed, selling downside protection (eg. selling cash-secured puts) has been a beloved strategy of retail investors this year, and the increased supply of left tail gamma may be one factor weighing on skew.

Similarly, the ratio of VVIX to VIX – ie. ratio of the implied volatility of implied volatility to implied volatility, is now at the highest level since mid-July, a month which marked a near-term top that kicked off a 3 month-long 10% correction in US equities. History may not necessarily repeat itself, but this does suggest the opportunistic purchase of relatively cheap equity hedges by investors in the form of volatility topside (and therefore the relative unattractiveness of selling puts by extension, as downside vol is cheap).

Interest Rates

Central bank decisions were in the spotlight this week as decisions from the Fed, European Central Bank (ECB), Bank of England (BoE), Swiss National Bank (SNB) and Norges Bank were due on Wednesday and Thursday. Undoubtedly Powell’s pivotal press conference was by far the single most important event and a major market-mover.

In an about-turn from his resolute no-cuts stance just over a month ago, Powell acknowledged that the FOMC discussed rate cuts at its December meeting, although the exact timing and magnitude of which are still up in the air. In alignment with the Chairman’s dovish pivot, the Dot Plot surprised markets as FOMC participants pencilled in a median of three 25bp rate cuts for 2024, more than the 2 cuts markets had expected them to signal. It was a clear proclamation of the end of the current tightening cycle. The market reaction was emphatic – the policy-sensitive US 2-year note rallied to touch a low of 4.28% on Thursday, marking a nearly 100 basis point move since the late-Oct highs. STIR futures moved to price in more than 220bp of cuts over 2024 and 2025, with an 80% chance of a 25bp rate cut by the March 2024 FOMC meeting.

Unfazed by the Fed’s pivot a day before, Thursday saw renewed attempts at pushback from the ECB and BoE, both reiterating that it was too soon to consider rate cuts. While President Lagarde appeared moderately successful at first as interest rates ticked higher following her press conference, bond bulls stepped back into the fray to reverse the move by Friday’s close.

Apparently unsettled by the market reaction, Fed President Williams appeared on a CNBC on Friday to push back against market pricing, insinuating that markets had gotten ahead of themselves, and it was “premature” to be considering a cut in March. While bond yields briefly rose after Williams spoke, his efforts were in vain as traders once again called his bluff and interest rates quickly reversed course.

Short Term Interest Rate (STIR) Futures moved quickly to price in additional rate cuts following this week’s developments. Markets now expect ~140bp of Fed cuts in 2024 – nearly six 25bp cuts spread across 8 FOMC meetings, a huge jump from the ~80bp priced for 2024 just 6 weeks ago.

As a rough measure for the distribution of rate cuts between 2024 and 2025, the SOFR H4-H5-H6 butterfly surged to touch a high of 120bp on Thursday on back of the intense front-loading of rate cuts into 2024 (see chart below). Pricing for the Fed’s terminal rate now sits at ~3.25%, expected to be reached around 1Q2026.

From an economic perspective, rate cuts are the logical next step given that recent data shows inflationary pressures have diminished and holding interest rates far above neutral (the r-star) for too long risks dragging the economy into recession. Central banks are, as always, treading a difficult path – pivoting too late and too little risks causing an economic slowdown, while pivoting too early and by too much risks the return of inflation, and even more so it risks inciting the markets’ worry that policymakers foresee a sharp slowdown ahead and acting pre-emptively (“do policymakers know something about the economy that we don’t?”).

The following graphics visualize the changes in rate cuts priced by markets over the past 6 weeks.

USD SOFR

EUR 3M EURIBOR

GBP SONIA

The Week Ahead

As markets wind down into year end, thinning liquidity and favourable seasonality (“Santa Claus rally”) should keep risk assets supported, especially in equities. While signs of froth may be emerging and there are emerging signs of protection-buying, it will take a lot to derail the current bullish momentum in markets. Many investors were under-invested throughout 2023 and may be resigned to chasing the market melt-up into year-end. Markets love a target and the 2021 all-time highs in US Equity Indices are likely to be breached in the final two weeks of the year. Santa Claus is coming to town.

The final major event of the year is the Bank of Japan on Tuesday (19-Dec), which will be closely watched by the Rates market for additional signs that confirm a committed shift toward normalising interest rate policy. UK inflation data is also due on Wednesday (20-Dec), which will be instrumental in influencing the priced path of BoE interest rate cuts for 2024.

Market Musings (8-Dec-23)

Equities:

The slow grind higher in US equities persists with the S&P500 touching a fresh YTD high on Friday. Market volatility remains subdued as the index remained within its ~1.5% trading range over the last 2 weeks. Paradoxically, sentiment indicators and volatility gauges suggest a whiff of complacency setting in as the festive season is around the corner.

 
Things were not so sanguine in China. The CSI300 and Hang Seng extended last week’s selloff and sank to new YTD lows, in part catalysed by Moody’s credit rating downgrade (which was fiercely rebutted by Chinese authorities). Commentators then quickly seized the opportunity to contrast the growing rift between India’s roaring stock market and Chinese markets stuck in the doldrums. In Japan, the age-old negative correlation between stocks and the JPY returned to the fore, with equities taking a hit as the yen surged (more on this below).
 
Commodities:
Energy markets continued their tumble following last week’s disappointing OPEC+ cuts announcement and renewed doubts about Chinese demand as the economic situation remains soft. Slight reprieve came on Friday after the US Department of Energy announced plans to purchase 3 million barrels of oil for refilling the Strategic Petroleum Reserve, helping WTI crude close the week above the psychological $70 level.
 
Spot gold kicked off a dramatic week in precious metals, surging to a record high above $2100 in usually-lethargic Asian Monday morning trading, taking out many stop losses along the way. Inflicting even more frustration, the entire surge higher was retraced within the same day by the time Europe opened for trading. While gold managed to hold within a trading range for most of the week, silver continued to slide throughout the trading week before escalating into a full-blown crash on Friday following stronger-than-expected US payrolls, capping off a bruising week down 9%. No doubt the whacky price action in precious metals caught the attention of mainstream media – I recall seeing searches for “gold price” trending on Google.
 
Cryptocurrencies:
Another banner week for crypto as Bitcoin pushed above $44,000. Other large-cap L1s surged to fresh YTD highs (eg. ETH, SOL, AVAX). Mainstream interest in crypto is resurfacing, based on empirical and anecdotal evidence (own observations), and the stars appear to be aligning for a new bull run. Planning to pen my thoughts on crypto if I can find the time.
 
Spot FX:
The US dollar regained some luster this week after a soggy November, gaining ground against most major currencies except the JPY, which saw the largest one-day surge since last December after speculation of an earlier-than-expected BoJ policy normalization following Deputy Governor Himino’s comments that a properly executed exit from negative rates would reap economic benefits. JPY strength was further catalysed by Thursday’s extremely weak 30-year Japanese Government bond auction which saw the biggest tail on record.

Interest Rates:
Front-end rates in major markets largely reversed the previous week’s rally after US NFP, while persistent buying interest in long-dated government bonds kept downward pressure on long-end yields. Japanese Government Bonds (JGBs) were in the spotlight after yields jumped on a ferocious selloff following Himono’s comments and lackluster 30y auction. Notably the selloff in 10Y JGBs opened a rift with 10Y Treasuries, leaving one to muse whether the tail (JGBs) could soon wag the dog (Treasuries) in spurring a reversal of last month’s sharp Treasury rally.

Over in short-term interest rates, markets walked back pricing for a March FOMC cut following a firm employment report on Friday. Rate cut pricing for the European Central Bank (ECB) however remained sticky as markets continued to look through ECB officials’ often half-heated attempts to pushback against cuts pricing.

US inflation breakevens tracked the trajectory of oil prices, bouncing higher after touching the lowest levels in 2 months. In the cross-market space, Australian 10y bonds outperformed their US counterparts, as traders were unimpressed by the neutral tone struck by the Reserve Bank of Australia (RBA), following a softer-than-expected inflation print last week and promptly set about fading what remained of the rate hikes priced for early-2024.

Credit spreads remained priced for a no-landing economic scenario, with high yield spreads continuing to tighten as sentiment remained buoyed into year-end. US CCC spreads (in deep junk territory) continued to tighten from their late-Oct highs.

Volatility:
Reflecting the subdued realized volatility in large-cap US equities, the VIX closed at a new YTD low on Friday. Perhaps another sign of market complacency setting in, S&P500 options skew (as measured by the Nations SkewDex Index) cheapened to a new low this week – hedging tail risk has never been cheaper on a relative basis.

The Week Ahead:
Next week brings a litany of central bank meetings. Among the G10, the Fed, European Central Bank, Bank of England, Norges Bank and the Swiss National Bank are due on Wednesday and Thursday.

US CPI on Tuesday will be closely watched and will likely determine market direction for the remainder of the year. A 3.1% y/y headline reading is expected. A slight miss or in-line print would likely reinforce the notion that inflation has been beaten and rate cuts can now commence in 1H2024, likely sparking another rally into year-end should the Fed maintain its current posture at the following day’s FOMC decision. It would take a large beat on the inflation front to shock markets into reversing the rate cuts priced, given how deeply entrenched the disinflation narrative (albeit well-supported by data) has become.

7 Predictions for ’17 – An Outlook for the Year Ahead (Part 2)

[This is the second part of a two-part post. The link to the first part can be found in the navigation panel on the right]

4) Currencies

USDSGD

It is well known that the Monetary Authority of Singapore (MAS) intervenes on our currency from time to time, to keep it within the unspecified trading bands that it sets. While the MAS has held off depreciating the Singdollar outright policy-wise, a slowing local economy coupled with shifting global fundamentals could see it change its stance and guide the Singdollar lower. 

The local economic backdrop is rather bleak. Singapore’s economy grew at a sluggish 1.8% in 2016, according to preliminary readings, the lowest growth rate since 2009. This lackluster economic environment looks set to continue, as economists predict 2017 growth to be between 1% and 3%. With US interest rates and yields set to rise in 2017, the US Dollar has been on a tear against its developed country counterparts in recent months. 

Against the Singdollar, the USD jumped from 1.3940 SGD to 1.4440 SGD within this period.

Such a sharp move in recent memory is only rivaled by the late 2014 surge in the USD. The fact that such a sharp drop in the SGD was allowed to happen does hint at a lack of outright intervention by the MAS. While the MAS could have intended to depreciate the SGD, market movements in recent months could have already fulfilled this intent. Sharp resistance was met in recent weeks as the USDSGD pair approached 1.45, not unlike how the USDJPY pair behaved as it approached the critical 100 level in early-2016. This could be government intervention. 

While much of the weakness in the Singapore dollar may already have been priced in, a further decline in the SGD later in 2017 should not be ruled out. Technically, the long term direction of USDSGD is up, implying a weaker SGD, as indicated by the series of higher highs and higher lows in 2015 and 2016. 2017 could see a higher low forming, should the pair correct from currently stretched levels at 1.44 and consolidate before moving off again.

The fact that the Singdollar is unlikely to appreciate strongly, while its weakness is an obvious conclusion for now, makes a long USDSGD trade attractive. With the risks skewed asymmetrically to the upside for USDSGD, long positions can be taken when the pair falls to more appetizing levels, such as the resistance-turned-support 1.3940 level. However, retracements are likely only to correct the pair to 1.4200. A reasonable long term price target could be 1.4800, and subsequently 1.5000. 

The key risks to this long position would be a drastic shift in MAS policy, a reversal in the direction of the US dollar or a stronger than expected Singapore economy. 

USDSGD Prediction

Verdict: Bullish

Predicted End-2017 Level: 1.4800

Worst-case-scenario Level: 1.3600

Immediate Resistance Levels: 1.4370 (127.2% Fib extension), 1.4540 (138.2% Fib extension), 1.4600 (psychological level)

Immediate Support Levels: 1.4200 (2010 highs and psychological level), 1.3940 (early-2015 peak, recent resistance-turned-support)

EURUSD

With the pair finally breaking below the 2015 decade-low at 1.0460 in late 2016, there has been much chatter about the pair reaching parity (1 EUR = 1 USD). The euro has never been at parity since the last time in late 2002. This important level will be extremely closely watched by the financial world. 

Technically, the euro has broken out of a box formation (sorry I didn't include a zoomed-in chart for this period) formed since early 2015, where it was stuck in a range between 1.05 and 1.15. A trendline (green diagonal line) can be drawn connecting the series of lower lows since 2008. With woes in the Eurozone (the latest being Italian banks) affecting confidence in the single currency, parity with the USD does look plausible for the EUR at this juncture.

With the eurozone beleaguered by a litany of economic woes – continued sluggish economic growth, negative interest rates and quantitative easing failing to deliver solid results, weakness in the Italian banking sector etc, as well as geopolitical uncertainties – French and German elections, the actual act of Brexit set to happen in 2017, the threat of populist governments moving to leave the Euro, immigration and refugee problems and so on, it is hard to make an optimistic bullish case for the single currency. (Phew, that was a very long sentence!)

The UST-Bund yield spread (see chart below) between the 10 year US government bond and the 10 year German counterpart (the bund, a good benchmark of European yields) has been widening since the US elections, putting further downward pressure on the euro as “hot money” rushes out of European bonds and into US ones. [The spread here refers to the difference in yields between the respective 10 year bonds]

While EURUSD parity seems nearly inevitable at this point, I do not think the road there will be a straight line. For one thing, widespread expectations do not necessarily translate into immediate market movements. There are far too many short positions on the euro at present to support a straight line trajectory toward parity. Not to mention probably huge open interest for options written against that level. With so many players betting on a move to parity, the market will therefore move to “shake out the weak hands” first. 

Therefore, I would not be surprised to see a rebound to 1.08 first before the golden level of 1.00 eventually comes, spurred by short covering on this crowded trade. The sudden surge in EURUSD on 30^th Dec 16, the last trading day of the year, gives us an insight. The fact that the euro rocketed more than 100 pips (1 cent) in less than 10 minutes under thin liquidity conditions seems to hint of numerous stop loss orders on short EURUSD positions being hit, fuelling the spike that was probably started by computer algorithms. In a one-sided market with so many short positions, achieving parity would not be so simple. 

At times when expectations are so one-sided, a big rally in EURUSD after some unexpected news or developments would certainly catch everyone off guard. It does pay to consider the contrarian side of the matter. (Just remember Brexit and Trump) 

Then again, the euro may fall beneath the 1.000 level, only to rally off again in the following weeks, should Eurozone data trump expectations. A key risk to the short euro trade would be the European Central Bank (ECB) tapering its asset purchase program earlier than the market expects. 

EURUSD Prediction

Verdict: Moderately Bearish

Predicted End-2017 Level: 1.0000

Worst-case-scenario Level: 1.1300

Immediate Resistance Levels: 1.0460 (market likely to converge around this level), 1.0600 (psychological)

Immediate Support Levels: 1.0460, 1.0150 (23.6% Fib level), 1.0000 (psychological)

5) Bonds 

Probably the least disputable asset class in terms of direction would be bonds. Although I am wary of black swan events that could derail the upward trajectory in bond yields, I go with the consensus view that the US 10 year yield could touch 3.00% in 2017, while yields continue to rise across the entire yield curve.

What is worthy of debate then, is whether the US yield curve steepens or flattens in 2017. 

Following the victory of Donald Trump on 8^th Nov, the US yield curve has somewhat steepened, [Comparing the blue line (recent) and the green line (before elections), we see that the difference between them widens as we move along the x-axis (maturity).] and that yields have generally increased across the board. The following chart shows a good proxy for the gradient of the yield curve, the yield spread between the 2 year and 10 year Treasury Notes. [Both of which are bonds, despite being called “notes”] As seen, the spread has jumped dramatically since Trump’s victory, implying that the yield curve has steepened quickly.

This does not come as a total surprise, as President-elect Trump has promised large fiscal spending to boost the economy. The influx of government spending in an economy widely viewed to be already at full employment and with no excess capacity is likely to cause inflation, and therefore bond yields have increased to price in increased inflation expectations. Since inflation expectations affects the longer end (bonds of longer maturity) of the curve more than the shorter end, the shift in the yield curve is not parallel and the curve steepens in this case. 

While the yield curve may be steepening on inflation expectations, the effect of interest rate hikes by the Fed cannot be neglected. Successive and rapid rate increases are likely to raise the short end (bonds of shorter maturity) of the yield curve to a greater extent than the long end, causing the yield curve to flatten. Conversely, a slower paced series of rate hikes gives the market more time to adjust. In this case, the curve would likely see a more parallel shift upward, flattening to a lesser extent. 

Combine Trump’s big fiscal spending plans with the three forecast rate hikes for 2017, and a very conflicting outlook is painted. Since the markets tend to go ahead of themselves and price in changes way in advance of them even happening, the rapid ascend in bond yields so far could have been overdone. On the other hand, not many have considered the possibility that the US economy may not have hit full employment yet, and there is still spare capacity to accommodate higher aggregate expenditures, resulting in lower levels of inflation than expected. 

Predicting the Fed’s moves are easier said than done, but what if the Fed holds off raising rates until mid year, followed by 3 hikes in rapid succession? Couple that with lackluster inflation and the result could well be a flatter yield curve. 

There are too many “what ifs” at this juncture that clouds one’s crystal ball, but if I were to make a bold prediction, I’d go against the consensus of a steepening yield curve.

6) The Fed

Obtained from the Federal Reserve website

 

The Fed has been promising rate hikes since 2014, but so far has only delivered two – once in December 2015, and the other in December 2016. Yawn, Wall Street has probably found a new obsession to fret over in 2017.

While I believe that interest rate hike expectations are now less likely to impact the stock market, its effect on fixed-income markets is still going to be profound. Trying to predict exactly when and how many rate hikes will take place has become the staple of market pundits. I have 3 scenarios in mind about how the Fed could move in 2017:

1) 2 hikes in 2017, first in June, another in the 4^th quarter

2) 3 hikes in 2017, one in the first quarter, then June, then year end

3) 3 hikes in 2017, first in June, then September, then December

The first is the most “popular” scenario by far, and one agreed upon by the experts. Currently, the Feds Funds Futures imply a more than 50% chance of a rate hike in June, which would bring rates to between 0.75-1.00%. Before June, the probability of a hike does not exceed 50%, according to the futures. 

Hang on, doesn’t this prediction sound a little familiar? That’s because it’s exactly the same as the market expected back in early 2016. Back then, there was much talk of two hikes (as opposed to the purported four) in 2016, once in June and once in December. However, the unexpected arrival of Brexit derailed those plans.

This year, geopolitical risks seem comparatively more tamed, or has the short-sighted market discounted those risks for now? As the French and German elections approach, Mr Market could suddenly awaken in panic and fret over a black swan result, the exact opposite behavior of a complacent market going into the British Referendum. Would the Fed choose to hike interest rates in the face of geopolitical uncertainties then?

Later in the year, would inflation begin to creep up following huge fiscal spending, assuming they are passed? What if inflation doesn’t rise as expected? Or what if the Fed sees a lot of inflation on the way, and tightens rapidly in a “front running” effort? Or even more unexpectedly, what if the “fiscal-hawks” in Congress block Trump’s fiscal plans? 

Also, the Fed has a reputation to maintain, and their credibility is at stake here. Despite calling for the first rate hike to be in 2015, and expecting four hikes in 2016, the Fed has not upheld any of those promises. Nobody is going to take the Fed seriously anymore if they do not act on their words. 

More recently, Fed officials have mentioned that they are faced with uncertainties with regard to how fiscal policies in future may influence their decision to hike interest rates. Members also expressed concern over the strength of the US dollar, which has been jeopardizing the profits of US multinational companies as they repatriate them back to the US. In fact, some argue that the appreciation of the USD accompanied by rising bond yields have already done the Fed’s job for them, as these conditions are very similar to an interest rate increase.

There are way too many unknowns at this juncture to draw a solid conclusion and hence we have to make a logical guess based on what we have now. I foresee only two interest rate hikes in 2017, very likely once mid-year and the other year-end. With President-elect Trump promising huge fiscal spending and lower taxes at the same time, the only way this can be achieved is through huge borrowing. And in order for huge borrowing to be sustained without jeopardizing the solvency of the government, interest rates have to be kept lower for longer.

 

Much of the US recovery since the Great Recession is funded by cheap debt – cheap debt that is keeping inefficient “zombie” companies afloat rather than letting them fail. Should interest rates rise rapidly, it would cause a knee jerk effect on the delicate recovery and threaten a slowdown once again. 

7) "Market Mayhems"

There have been numerous outbreaks of sheer panic in the financial markets since 2015. Some extremely terrible things would happen (oh no Brexit!), or market players suddenly lose their cool over trivial matters, and the financial markets would tip over into chaos and disarray. 

A look at the CBOE Volatility Index (VIX), which measures the 30-day implied volatility of options on the S&P500 index (a simplified explanation), captures these instances of “market mayhem” over the past two years. The VIX is often used as a proxy measuring the fear of investors. The higher the VIX, the more terrified investors are. 

These spikes correspond to events that shook the financial markets badly one way or another. Notice that we have periods of “low to moderate” VIX in between these spikes. Notice how the index returns to “normalcy” in the months after a big spike. Also note the frequency of the spikes, which occur once every 5 months or so. Beginning to see a pattern?

Everytime bad things happen and it upsets the market, the reaction is likely to be sharp and swift, with stock markets plunging in an instant and hot money scurrying to the safe haven assets. However, perhaps after those who had panicked have calmed down, they begin to regret their impulsiveness and flock to buy into the market again, sending it rocketing back to the level it was previously and then even higher. I’m beginning to see this as a “buy the dip!” phenomenon, however nonsensical it may seem, illustrated in the chart below using the Dow Jones Industrial Average as an example.

Investors who “bought the dip” each time gleefully made buckets of money, while those who had panicked and sold out kick themselves in dismay. It does seem then, that “buying the dip” and then selling the recovery later is a viable trading strategy (not investing) for now, in the midst of a 7 year old bull market that seems to be invulnerable. Longer term investors can use such dips as attractive entry points, to buy quality stocks on the cheap.

Far from declaring that the market will always rise, I have to concede that this strategy has its fair share of risk. Looking back over a longer horizon, these “big dips” have become a far more frequent event. The big question now is: When does a big dip become The Dip – the beginning of the next bear market, the drop that the market doesn’t bounce back from quickly? Nobody knows. Regardless, do bear in mind that with the US market trading at historically expensive valuations (high P/E ratios) now, the risk of a substantial correction cannot be neglected. 

The Final Word

I have come to the end of my (extremely) long investment thesis for 2017, and for those of you who have been reading since the first paragraph of part one, you have my heartfelt gratitude. 

Naturally, I do not expect everyone to agree with my views and opposing views are definitely equally valid as well. Nobody can predict the future with 100% accuracy and therefore only time will tell if any of our predictions come true. Until then, it is better for one to form his/her own views and take a stand, to make sense of this chaotic mess that we call the financial markets.

Once again, a very happy New Year to all readers!

Just my two cents.