Last year was unusual in many respects for financial markets. When expectations for how events normally unfold become challenged by data way outside its normal range, it is easy to imagine the world has gone mad. A science-fiction genre exists where the protagonists have jumped to (or awoken in) an alternative world. Think The Man in the High Castle, the Star Trek episode “Mirror, Mirror” and “It Can’t Happen Here.”
To this group, you can add a new title: “Outlier 2017.” I can imagine the sonorous baritone voiceover during the opening scene: “It was a year filled with aberrations.” To wit:
-- Above average U.S. market returns;
-- Record corporate profits;
-- Even higher returns overseas, especially for U.S. investors when priced in dollars;
-- Record low market volatility;
-- Record high political volatility;
-- Fed funds rates near record lows;
-- Market interest rates near record lows;
-- Below normal inflation;
-- Low bond yields.
But those unusual data points are ephemeral, as statistical outliers always revert to historical means ― eventually. And so that is what we are living through this year. Indeed, if 2017 was a year of eccentricity, then 2018 represents a return to normalcy.
What has changed? Combine above average returns, the passage of time and a very specific technical event and you create the right environment for reversion. The U.S. equity markets have risen for nine consecutive years, and during seven of those nine years, it rose by double-digit amounts. It is easy to see markets getting a little ahead of themselves, and needing to digest those gains. Those who look at the longer market cycle after this fantastic run wouldn’t call a quarter or three of sideways action unexpected.
Why did volatility suddenly return? Consider that long run of gains by the broad indexes. Active traders and hedge funds found a profitable trade in making highly leveraged bets against volatility. Of the dozen or so exchange-traded funds and exchange-traded notes designed to make this bet, much of the capital was concentrated in just a few of them. The precise factor that precipitated the blow up of these products is unknown.
My best guess is that someone somewhere back in February decided enough was enough ― it was time to take their chips off the table. For some historical perspective, let’s look back to December 2006, when the VIX, which is sometimes referred to as the market’s fear index, hit a cyclical low of 9.39, just as the housing market began to stumble and stock markets were beginning their final run up ahead of the Great Recession and a subsequent 57 percent crash. For anyone looking for a technical signal that the moment had come to unwind a levered VIX trade, that time was as good a time as any.
As the VIX was getting closer to its record low of 8.56 in November 2017, my guess is a chain of events led large holders of the leveraged volatility notes to start cashing out. A trickle at first, then a flood. As so often happens, selling begat more selling, especially with this highly leveraged trade. Pretty soon, a vicious volatility cycle was underway. It wasn’t an outright panic, but rather, gradual selling that fed on itself, playing out over a few months, from November to February, when the VIX spiked to 50.3.
Why would selling volatility notes cause volatility to rise? There is an old adage on Wall Street that goes, “When you are under pressure, you don’t get to sell what you want, you sell what you can.” Meaning, whatever is liquid and easily converted into cash gets sold, often to meet margin calls. Anecdotally, some traders owned S&P500 ETFs market indexes as the underlying collateral for volatility notes purchased on margin. As volatility spiked, the value of the notes exceeded its value underlying the margin. When the trade began to get squirrely, someone needed to raise cash, and fast. This could explain why markets took a hit in response to a rise in volatility.
This is only theory, a surmise barely disguised as a guess. But it’s as good an explanation as any I have seen anywhere else.
The return of volatility changed the tone of the market. The reaction to various tweets by President Donald Trump was very different, even if Trump’s rhetoric was the same as last year. So why did traders respond to things in 2018 that they ignored in 2017? Your guess is as good as mine.
I have said before that presidents get too much credit for market rallies, and too much blame for their crashes. The “Trump slump” narrative is every bit as invalid as the “Trump bump” heard so often last year. But today, the world sees thing differently.
-- Barry Ritholtz, is a Bloomberg View columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm.
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Stocks to ponder
Premium Brands Holdings Corp. (PBH). Hungry for dividends? Premium Brands Holdings Corp. won’t make you rich on its modest yield alone, but the food company’s soaring share price and growing payout have hit the spot for investors. Since John Heinzl first profiled the fast-growing food manufacturer and distributor in March, 2017, the shares have produced a total return, including dividends, of about 53 per cent, crushing the total return of about 3.1 per cent for the S&P/TSX Composite Index. And there still is some potential to come (for subscribers).
Norbord Inc. (OSB-T). These are good days for Norbord Inc.: Profit is surging amid strong demand for its building materials. But even after impressive gains this year, Norbord’s stock has a curiously low valuation that appears to be reflecting concerns ahead – and that’s good news for investors, because these concerns are probably unwarranted. The Toronto-based company produces oriented strand board, or OSB, a type of wood-based panel similar to plywood and ideally suited to home construction. David Berman explains (for subscribers).
Restaurant Brands International Inc. (QSR-T). There’s no doubt about it: Tough, cost-conscious management is a vital ingredient at any good company. But right now, shareholders in Restaurant Brands International Inc. and Kraft Heinz Co. should be asking whether a lean and mean operating style is hitting its limits when it comes to peddling doughnuts and ketchup. In recent months, RBI, the parent of Tim Hortons, and Kraft Heinz, maker of your favourite burger condiment, have disappointed investors. RBI shares have lost nearly 20 per cent of their value since October, while Kraft Heinz’s stock price has slid by a third over the past year. Ian McGugan reports (for subscribers).
The Rundown
TSX short sales: Bearish investors are suddenly betting against this big-name marijuana stock
Canadian stocks with exposure to the marijuana sector remain a target of short sellers in April, according to short-interest data collected by The Globe and Mail. Other sectors in short-sellers’ sights, to a lesser extent, include small-cap financials exposed to the housing market, energy producers based in Alberta and fintech companies launching new financial technologies, such as blockchain. Larry MacDonald reports (for subscribers).
Another Big 5 bank is entering the ETF race
Another Canadian bank is preparing to enter the exchange-traded-fund industry, with Bank of Nova Scotia planning the launch of a suite of its own Scotia-branded ETFs. The bank’s asset-management division – 1832 Asset Management L.P. – has filed a preliminary prospectus with regulators for four ETFs: Scotia Strategic Fixed Income ETF Portfolio (SFIX), Scotia Strategic Canadian Equity ETF Portfolio (SCAD), Scotia Strategic U.S. Equity ETF Portfolio (SUSA) and Scotia Strategic International Equity ETF Portfolio (SINT). Clare O-Hara reports (for subscribers).
For new marijuana ETFs, it’s been a really rough start
Timing appears to be everything in the world of cannabis funds. Just over one year ago, the world’s first cannabis exchange-traded fund – officially known as the Horizons Marijuana Life Sciences Index ETF – started trading. Today, it has assets of roughly $700-million, a total return of 75 per cent since inception, and big inflows. But it’s a very different story for newer ETFs in the marijuana space. Three others launched in February but have struggled to grow their total assets. Matt Lundy reports (for subscribers).
Feeling adventurous? Six disruptive tech stocks
Investing in disruptive technology stocks can be enticing because of their huge profit potential, but it’s not easy to pick winners. These young companies are challenging the playbook of larger businesses or inventing new markets. They can experience high growth, such as Amazon.com, which has become the poster child for e-commerce disruption. Or they could become takeover targets. Given the recent stock-market pullbacks, which provide a cheaper entry point for investors, we asked three portfolio managers for their top picks among tech upstarts. Shirley Won reports.
Understanding a crucial yet mysterious fee investors pay their advisers
Look to the trailing commission you pay if you want to grade the value you’re getting from an investment adviser who sells mutual funds. Rob Carrick takes a look at different fees (for subscribers).
Top Links
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Others (for subscribers)
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Wednesday’s analyst upgrades and downgrades
Wednesday’s small-cap stocks to watch
Others (for everyone)
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‘Clash of the titans’ seen as U.S. marijuana startups duel Canadians
The elusive bond bear market may have already peaked
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Metals gripped by turmoil as Rusal’s sanctions fallout spreads
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Number Crunchers (for subscribers)
Looking for companies poised to post earnings surprises
Best of both worlds: Growth stocks that also pay a dividend
Ask Globe Investor
Question: Do you have any advice for coping with rocky markets? The violent ups and downs lately are causing me a lot of anxiety and I think other investors would also benefit from some soothing words.
Answer: John Heinzl has a few pieces of advice:
- Look at a long-term stock chart. Notice that, while there are lots of peaks and valleys, the general direction is up.
- Review the companies (or funds) you own. If you are confident that your companies will thrive for years to come – that their revenue, earnings and dividends will continue to rise – you should do nothing. The stock market will ultimately recognize their value.
- Instead of obsessing about stock prices, track your portfolio’s dividend income. This number should be rising steadily, through good markets and bad, and it won’t bounce around violently from one day to the next. Focusing on your portfolio’s growing income can be a source of comfort when the market is giving you fits.
--John Heinzl
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What’s up in the days ahead
Scott Barlow takes a look at what a flattening yield curve means, and David Berman examines the decline in tobacco stocks.
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Compiled by Gillian Livingston