Covenant Weekly Market Synopsis for December 14, 2018

December 17, 2018

Christmas is a time when kids tell Santa what they want and adults pay for it. Deficits are when adults tell the government what they want and their kids pay for it. – Richard Lamm

Last Week Today: November’s budget deficit was the largest on record for the US at $205 billion (vs. $129 billion a year earlier), as government spending jumped 18% with little change in receipts. | China signaled they would reduce retaliatory tariffs on imported US autos from 40% to 15% on January 1st, a positive (though in no way definitive) step in defusing the trade tensions between the US and China. As a reminder, the 90-day window for the US and China to make progress on the trade war expires March 1st. If no progress is made, the US is expected to levy additional tariffs on imported Chinese goods. | As anticipated, the European Central Bank announced it would end its Quantitative Easing program, but will continue to reinvest principal and interest payments. In other words, the ECB will cease expanding its balance sheet, but not yet begin reducing it. This is the same path followed by the Fed when it ended QE back in 2014. | Retail sales in November were well above consensus estimates, rising 7% year-over-year on a nominal basis, or 4.8% on a real, inflation-adjusted basis. Low unemployment and higher wage growth continue to support consumption, and while a positive indicator for economic growth, these types of data points give the hawks at the Fed more ammunition for continuing to raise interest rates.

Another volatile week in equity markets left the three major US stock indexes in a ‘correction’ (i.e., down more than 10% from a high). Despite the correction moniker, on a year-to-date basis, the S&P 500 (-0.9%), the Dow Jones Industrial Average (-0.3%) are barely below water on a total return basis, while the Nasdaq is up +1.2% (inclusive of dividends). For detailed weekly, month-to-date and year-to-date asset class performance, please click here.

FOMC – The Federal Reserve Open Market Committee, aka “The Fed,” will convene its final meeting of 2018 this week. In addition to announcing a decision on the current Federal Funds Rate (it is widely expected they will raise it by 0.25%), the committee will also update their interest rate forecasts. Previous Fed forecasts indicated a median prediction of four rate hikes (including one this week) by the end of 2019. Economists currently predict a total of 3 rate hikes. But those who invest money for a living and have real risk on the table via investing in interest rate futures, are only pricing in two more rate hikes. Heretofore, the risk takers have proven more accurate than the Fed or economists when it comes to forecasting the level of the Fed Funds rate, so the messaging around this Wednesday’s interest rate announcement will garner heightened attention.

Investor Sentiment – If the market moves this year, but more specifically in the last three months have taken their toll on your psyche, you are not alone. The ratio of Bulls to Bears (or those with a positive market outlook vs. a negative market outlook) is at lows rarely witnessed. The last time the ratio plumbed these depths was in early 2016 when the S&P 500 was in the midst of a correction (that began in late 2015), crude oil was bottoming at $26 per barrel, and fears were mounting that China’s economic slowdown was spinning out of control. 


Sources: Bloomberg and Covenant Investment Research

This corrective phase may not be over, and while the signal is noisy, extreme negative investor sentiment is often a contrarian indicator that marks the bottom (or near bottom) of a stock downturn.

Not Unusual. The chart below shows the history of the VIX Index, which is a market-based measure of near-term expected volatility in the S&P 500. Specifically, it represents the market’s expectation of 30-day forward-looking volatility, based on price inputs of S&P 500 Index options. The VIX Index is also known as the “Fear Index” because an elevated VIX Index indicates stress in the market which typically leads to lower equity prices.


Sources: Bloomberg and Covenant Investment Research

This chart includes a lot of data, but there are a few important takeaways:

  • The VIX Index itself is volatile. The annualized standard deviation of the VIX Index is approximately 70%, which is nearly 5x as high as the S&P 500’s annualized volatility level of 14.7.
  • Since 1990, the average level of the VIX Index has been 19.3 (depicted as “Average(1)” in the chart). Even when eliminating the outlier period surrounding the Great Financial Crisis, the average VIX Index level is 18.3 (shown in the chart as “Average(2)”.
  • A one-standard-deviation move in the VIX Index is 7.8 points, meaning that 68.3% of the time the VIX Index is between 27.1 and 11.5 (the grey-dotted lines). When considering two-standard deviations, 95.5% of the time the VIX Index is less than below 35.

When viewed in a historical context, the recent volatility does not appear as unusual as it might feel. Indeed, the low level of volatility experienced in 2017 is far more uncommon than the current volatility we are experiencing. What is also evident in this chart is that volatility is somewhat cyclical, with periods of low volatility (e.g., the mid-1990s and mid-2000’s) followed by periods of elevated volatility. We expect this pattern to hold. Following a period of mostly low volatility since 2014, financial markets are likely to be noisier going forward. As such, it will be important for investors to approach the market with a solid investment plan for navigating choppier seas.

Unusual.  While the level of volatility is not particularly surprising based on 30 years of data, 2018 is an unusual year for a different reason. In the absence of a strong rally in either the stock market, the Barclays Aggregate Bond Index, or both, 2018 will be only the second year since 1988 in which cash has outperformed these investment stalwarts.


Sources: Bloomberg and Covenant Investment Research

If there is good news from the rather fallow investment landscape of 2018, it is that these types of years are highly uncommon. Thus, while the markets may be more volatile going forward, investment returns on risky assets are likely to be higher.

Be well,