Last week saw some turmoil and a sharp spike in the VIX, which led to some rare backwardation in VIX short-term futures (VXX, UVXY). The increase in volatility and sudden decline in stocks, including a fall below the 200-day DMA which some traders saw as an indication of a full-blow bear market, was attributed to many things in the popular media. Ebola, civil unrest, disappointing initial earnings, stagnant wages. But in reality, none of these really accounts for the sudden downturn in equities that we saw.
This is especially obvious when we look at what happened on Thursday and Friday, when the market saw a bottom and began to recover. The beginning of a recovery, as fast as the correction began just a week ago, suggests that there are two culprits to the market. Understanding this is important, because it means macro strategies remain essential to producing alpha, even after the QE taper was predicted to bring back fundamental investing and an end to the “buy the dip” post-2009 market.
Capital Flows, QE, and Oil-Based Deflation
The significance of quantitative easing to the stock market is easy to show with one chart:
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This chart, which I’ve taken from this website, makes one thing clear: stocks go up during periods of QE, and go down during periods of no QE. Thus the tapering of this latest round of QE, which is set to end this month, should mean a bear market. That is what we began to see last week.
Then something strange happened yesterday; the Federal Reserve responded to the market. St. Louis Fed Bank President James Bullard said on Thursday morning that the Federal Reserve could consider extending QE. Looking at the market chart since then, it’s easy to see that traders loved this idea a lot:
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If stocks rise with QE and fall without, traders began betting aggressively that Bullard’s words would turn into a new round, so it was best to buy this dip before it turned. But there is no QE yet—just an assurance to the market that the Fed sees your momentum and will respond to it if need be. As one commenter on SeekingAlpha put it, “VE (verbal easing) is the new QE.”
Before the recovery began on Thursday, one fear was that the economy would hit a deflationary spiral as inflation rates slowed to a trickle, and threatened to disinflate to a point of negative rates. Key here is oil, which has gotten cheaper and cheaper in recent months thanks to an oversupply, strong production in the U.S., and a decline in demand from emerging markets. All of this caused gas prices to fall in the U.S., and some economists feared that too cheap oil could cause production to grind to a halt, and possibly exacerbate geopolitical instability in the Middle East and Russia.
The threat of deflation was enough to give the Federal Reserve room to ensure that it would step in and keep a deflationary spiral from happening, which boosted markets. This makes sense, because much of the decline was due to fears that the deflationary spiral would cause all growth to halt in the U.S.
Cap Utilization Rates, Discretionary Income, Oil Prices
The market may not only be reacting to the Fed (although it might), because some other good news bolstered the case for investing in American stocks to benefit from future growth. Thursday morning, unemployment claims fell to their lowest level since 2000. Industrial production rose, and capacity utilization rose 1.4% above its point a year ago. Housing starts were decent, but commercial real estate demand grew at a robust pace, indicating future investment to profit from future consumer demand in the U.S. All of this was very good news, and reason for the stock market to rise on its own.
The issue of consumer demand brings us back to oil prices. With oil cheap as it is and an oversupply keeping prices low, U.S. consumers will be able to spend more money on gas, meaning they will go on more shopping trips. They can also spend more on flights, meaning they will go on more vacations. Companies can also spend more on energy-intensive initiatives to produce new products, which can encourage demand. Also, more money left over after paying heating and travel bills will mean Americans can buy more stuff elsewhere, creating a virtuous cycle of demand and corporate revenue growth.
That on its own, without the Fed’s intervening, could be enough to keep the S&P 500 up, particularly if the index’s price to index ratio is bolstered by revenue growth, which has been struggling since the 2008 recession. Thus with or without a Yellen put, investors had enough reason to re-enter the market, as the risk of a bear market eroded, if not fully evaporated.