Let’s talk about this market sell-off, and what is—and is not—going on here.
Since the start of February, the global equity markets have fallen 6%, losing all of its gains for the year as volatility soared. The most violent of moves occurred on Monday, February 5, when the Dow Jones Industrial Average plunged 1,500 points intra-day and the S&P® 500® Index was down 4% to end the day, prompting worries that we are witnessing a “flash crash.”1
While this market action has been a bit “flashy,” it is nowhere near the degree of past flash crashes where severe market dislocations occurred. The magnitude of this week’s market moves can be partly explained by the coordinated unwinding of speculative positioning against a backdrop of anomalously low market volatility and euphoric sentiment.
The likely path forward for markets is positive given the stability of macroeconomic data, supportive global growth and positive earnings sentiment globally. However, given that 2018 could witness changes in both monetary and fiscal policy in the US and abroad, investors should expect more idiosyncratic episodic market volatility—a trend that is commonplace for a market in the later stages of a cycle.
Here are 3 key takeaways from this market sell-off:
Takeaway 1: Walking through the dust as it settles paints a picture of euphoric positioning
The equity markets sold off as a result of a myriad of factors from macro to sentiment to positioning. Heading into February the market was facing prior persistent trends of euphoric exuberance, partly a result of a noticeable boost in earnings estimates for 2018—the growth rate surged more than 5% to a projected 16.6% since the Tax Cuts and Jobs Act was signed.2
Charting euphoric investor sentiment
The chart below shows the Relative Strength Index (RSI), which tracks investor euphoria. RSI had traded over 70 for 18 consecutive days. This was the longest such streak in history. The RSI is now below 30, which indicates oversold.
Source: Bloomberg Finance L.P., as of 2/6/2018
This euphoric sentiment was combined with a historically low starting point in levels of market volatility across multiple asset classes, leading to significant net long positioning in key exposures, such as equities and oil, combined with significant short positioning in interest rates and the US dollar. Sentiment and positioning were now at elevated levels.
A glimpse of significant net long positions
Our second chart, capturing futures positions, reinforces our belief that traders unwound long oil, long equity, short dollar (not shown here) and short interest rate positions. This sent rates on 10-year US Treasuries to 2.7%.
Source: Bloomberg Finance L.P., as of 1/31/2018
Beyond the sentiment and the positioning that contributed to the exuberance, and likely the fall as well, the market was also bearing the brunt of the uptick in inflation expectations. This was a result of the tax reform bill that sent interest rates in the US to their highest level since 2014.3 These higher inflation expectations led the market to expect a more hawkish Federal Reserve (Fed) interest rate hike cycle, evidenced by the probability of a fourth rate-hike by December of 2018 increasing to over 20%. (This sentiment has since reversed course as the market sold off.)
Inflation expectations increased, pushing bond yields higher
This final chart shows that as investor expectations of inflation increased, so did interest rates. The takeaway is that historically low interest rates and inflation resulted in lofty stock valuations. Once they began increasing, investors were naturally re-rating valuations to reflect the new reality.
Source: Bloomberg Finance L.P., as of 2/6/2018
Takeaway 2: ETFs helped, not hurt, during this selloff
There is a common refrain to blame ETFs for any market turbulence. I say this is #FakeNews.
Let’s look at the facts behind the recent selloff:4
- For funds focused on the US equities in aggregate there was $11 billion of gross primary market activity (absolute value of creations/redemptions. This shows the activity where it would necessitate any impact at the stock level).
- There was $340 billion of trading volume on the underlying stocks in the Russell 3000® Index.
- Therefore, US Equity ETFs only traded 3.3% of overall trading volume in the underlying market!
So did ETFs broadly negatively impact the selloff? No. How can something that represents 3% of the market lead to the market falling more than 4% on a single day? ETFs performed their role as a market tool for price discovery, allowing investors to make capital allocation decisions in real time based on the market environment.
Given the headlines, I must address Exchange-Traded Products (ETPs) that short the CBOE Volatility Index® (the VIX®). Those exposures had an impact on the VIX futures market, but not the overall equity market. The VIX futures market impact was captured in post-market trading on Monday when the VIX increased 20 points—the largest absolute or percentage change ever. This VIX move was estimated to be a result of covering inverse ETP’s short future positions and adding to levered product’s long positions. Clients with holdings in these products witnessed their value plummet—underscoring why State Street Global Advisors does not offer these types of exposures, as it does not fit our ethos of responsible innovation.
Takeaway 3: This market selloff has created more opportunities for investors because of these four factors:
- Valuations have come down off “frothy” highs. The S&P 500 Index forward 12-month price-to-earnings ratio is now at 17 times, which is below the 25-year average.5
- Earnings growth is strong. Fourth-quarter earnings growth is tracking up 13% year-over-year while sales growth is up 8%.6
- Earnings sentiment is strong. Firms are beating sales estimates by 0.9%, which is more than four times the five-year average beat of 0.2%. At the same time, 69% of firms are beating on earnings per share, 79% are beating on sales and 59% are beating on both. This puts companies on track for the most beats since 2000.7
- Global growth remains robust as the Eurozone is on track for the strongest growth since 2010. The IMF recently upgraded global growth forecasts by 0.2% to 3.9% for 2018 and 2019.8
Looking at the opportunities now, from a sector perspective, financials represent a potentially attractive opportunity based on value, growth, momentum and earnings sentiment. Overall, the key message is that while this sell-off and spike in market volatility is unsettling; remember that last year, 45 out of the 47 countries in the MSCI ACWI had positive returns.9 Even with this sell-off, the S&P 500 Index is up 18% over the past year.
As always, we’ll be watching closely as events unfold, so stay tuned to SPDR® Blog for our latest market insights.
1Bloomberg Finance L.P., as of 2/6/2018
2FactSet, as of 1/30/2018, based on Consensus Analyst Estimates
3Bloomberg Finance L.P., as of 2/6/2018
4Bloomberg Finance L.P., as of 2/6/2018
5Bloomberg Finance L.P., as of 2/6/2018
6Bank of America Merril Lynch, as of 2/5/2018
7Bank of America Merril Lynch, as of 2/5/2018
8International Monetary Fund, as of 1/22/2018
9Bloomberg Finance L.P., as of 12/31/2017
CBOE VIX Index
The VIX Index is short for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options.
A very rapid, deep, and volatile fall in security prices occurring within an extremely short time period.
MSCI ACWI Index
The MSCI ACWI Index is a free-float weighted equity index and includes both emerging and developed world markets.
Price-to-Earnings Multiples, or P/E Ratio
A valuation metric using the ratio of the company’s current stock price versus its earnings per share.
Relative Strength Index (RSI)
A momentum indicator developed by noted technical analyst Welles Wilder, that compares the magnitude of recent gains and losses over a specified time period to measure speed and change of price movements of a security. It is primarily used to attempt to identify overbought or oversold conditions in the trading of an asset.
Russell 3000 Index
The Russell 3000 Index measures the performance of the largest 3,000 US companies representing approximately 98% of the investable US equity market.
Smart beta defines a set of investment strategies that use alternative index construction rules to achieve outperformance over first-generation market capitalization based indices. Smart beta indices isolate six particular “factors”—small size, value, high yield, low volatility, quality and momentum—and are again designed to deliver better risk-adjusted returns than cap-weighted indices.
S&P 500 Index
The S&P 500, or the Standard & Poor’s 500, is an index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices.