I’m not one of those people constantly calling for an equity correction.  Last year, when everyone was on the “October crash” bandwagon, I said while this was possible, that seemed liked a crowded trade and that the positive EV (expected value) was probably to the upside.  Most “analysts” will just look at something simple like a P/E ratio and not consider the other things going around them… like the corporate tax reductions, individual tax reductions, repatriation, a new infrastructure spending plan, the popularity of short vol strategies, and global central bank QE.  If you weigh all of the above, it makes sense that equities would stay supported.

As equities continue to rise, many of the supportive factors start getting fully priced in, and some of the things may start going the other way.  In particular, we had tax reform legislation pass.  So that is fully priced in.  The Fed has started tapering their QE reinvestments.  The ECB reduced their QE and may make another downside adjustment later this year.  The BOJ is not doing anything with their QE, but the markets like telling the story that they are.  A few weeks ago, I told CA newsletter subscribers to be wary of equities.  Since that time, we have had several new developments:

  • Longer term rates have increased. Longer interest rates have increased noticeably, and there is some chatter tens could go north of 3% from increased issuance.  One of the supports of equities has been that the S&P dividend yield was not that much different from ten year yields.  The difference is now 100 basis points.  If you are one of the many Baby Boomers about to retire, do you want to risk losing another 10% in equities, or take an additional 100bps in fixed income?
  • FAANG earnings reports were mostly not commensurate with the high expectations. Facebook had users spend less time, Apple had weak iPhone sales, I’m not sure Netflix can grow much more, and Google had weaker earnings.  Someone remind me while these companies deserve a high multiple?  It’s all priced in (and maybe more).
  • Drug prices will get killed by next year. I thought it was interesting that Trump mentioned targeting drug prices in his State of the Union speech.  An ambitious plan could emerge ahead of the elections, because this is something that voters care about.  With Amazon dipping a toe into the drug business, I think Big Pharma stocks and the stocks of the entire distribution chain will get crushed.  They have been ripping off consumers and businesses for years.  One time, I had to get some eyedrops for my son, and with insurance it was $150.  With a free GoodRX card, it was $15.  Someone at Blue Cross clearly is not doing their job of negotiating rates.  As Jeff Bezos has said, where there is margin, there is opportunity.  Big Pharma has crazy margins.  This will be bad for those stocks, and for inflation.
  • Direct volatility strategies got monkey-hammered. VIX selling caused markets to be constantly bid and volatility to be lower.  We may get some interest in selling vol at the current levels, but since people got burned, the interest will be less than before.  Most of those funds shorting the VIX lost everything.  This factor will cause the “buy on dips” strategy to be less effective.  But there are many other forms of selling volatility strategies out there.  I mentioned a podcast last week[1] that discussed some of the short volatility strategies.  A follow-up podcast is here: https://www.macrovoices.com/podcasts/MacroVoices-2018-02-08-Jared-Dillian.mp3.  There are other indirect ways of being short volatility.  Not all of the portfolio strategies rebalance daily.  So as the indirect strategies rebalance, we could get weeks, if not months of volatility.

It was not much of a surprise that equities had a large tumble from lofty levels.  People who have been used to buying aggressively on dips (since that is a strategy that has worked well for almost a decade) may be disappointed this time around.  There were reasons in the past to think equities would stay supported.  As I just discussed, this is no longer the case.

If this was April, and we just had the great Q1 earnings from the tax plan and repatriation, I would say it was likely that equities will decline, because there would not be much to look forward to.  But this is only February, and it’s possible that people could want to buy equities in anticipation of that positive Q1 earnings report.  Direction in the short term is going to be hard to call right now, but by Q2, I would think equities would be lower all other things being equal.

[1] I mentioned the following podcast last week: https://www.macrovoices.com/podcasts/MacroVoices-2018-01-25-Chris-Cole.mp3