Zeller Kern’s Investment Monitor

Being Reintroduced to Volatility

February 7, 2018

By Steve Zeller

Investors seemed to have a change of heart compared to a few weeks ago, as we reported back on January 21st, that the markets were up over 5% on the major indexes including the S&P 500, the Dow Jones Industrial Average, and the NASDAQ. But now, investors appeared to be off the deep end with a minor panic last week, as the market suffered its worst weekly sell off in two years. The Dow Jones Industrial Average suffered a plunge of over 600 points, as investors reacted with worry of inflation and spiking interest rates, after the favorable jobs report on Friday. The Dow Jones Industrial Average closed down -665.75 on Friday. The market, which has pulled back approximately 4% off of its highs, hasn’t seen this kind of volatility for a few years. Selling on the institutional side was aggressive. Momentum like this on the sell side is somewhat ominous as it tends to build momentum. This proved to be true on Monday, when the Dow plunged another 1,175.21 points, putting the market into correction territory off of the highs earlier in January. Now the market is actually down for the year (just over -1%), as of the market close on Monday.

From a technical standpoint, there was very little to indicate that this was on the horizon. One observation is that within the hour of the FISA memo being released, on Friday, the market began to roll over.

Investors’ panic was partly due to rising bond yields and the realization that the 35+ year bull market in bonds may be over. It is the opinion of some technical analysts, that the 10-year Treasury Bond yield hit its final low in July of 2016, at approximately 1.46% yield. And now with the acceleration of the economy, coupled with bond investors becoming bearish, as well as the Fed’s commitment to unwind its balance sheet, the 10-Year Treasury yield spiked above 2.8%, closing on Friday at 2.854%. But as we have been saying, the market has rung up gains backed by record positive sentiment, record margin debt, and frothy valuations.

The Fed’s growing commitment to unload the assets on its balance sheet, mainly consisting of Treasuries and mortgage-backed securities, is putting increased pressure on the value of Treasuries, hence contributing to the spike in yields.  According to an article posted on Wolfstreet.com, titled: “Fed’s QE Unwind Accelerates Sharply”, the Fed has completed its fourth month of a QE unwind and it is starting to take its toll. With the Fed announcing last September, that it has a goal of shrinking its $4 trillion balance sheet by $10 billion per month in October, November, and December, and then to accelerate even more in the following months, appears to be having a negative impact on those bonds. Also according to this plan, balances of Treasuries and Mortgage Backed Securities will shrink by $420 billion in 2018, by an additional $600 billion in 2019, and by an additional $600 billion every year following, until the Fed deems the level of its holdings “normal, according to the wolfstreet.com article.

So how is all of this panning out so far, this year? Well, according to Wolfstreet.com, on December 27th, the Fed’s balance sheet had $2,454 billion of Treasuries. But by January 31st, it had $2,436 billion, which is a drop of $18 billion in one month.

Since October, the Fed has allowed $9.5 billion in Mortgage Backed Securities to roll off of its balance sheet, or not replace them when they come due.

We’re not really sure how the Fed can get out of a balance sheet of this magnitude without significantly disrupting the asset markets, ultimately, and the flow of money within the economy. In other words, it may cause the eventual dry up of the "easy money".

Meanwhile, corporate bonds have been resilient to the Treasury sell-off, which is odd, especially when equities are selling off. Perhaps, investors view “Corps” as a safer place because of the prospects of a growing economy. So, as the Fed sells off Treasuries and Treasury yields rise, the corporate bond market remains intact. Even Tesla, with its bond ratings on the verge of “junk” status managed to sell $546 million in bonds last week. S&P rates Tesla “B-“, which is one notch above the official junk status of CCC.

The appetite for junk bonds is alive and well, with the record low junk-bond spreads, in October of 2017, the race to the bottom frenzy that occurred during the period preceding the 2007-2009 credit crisis, has since been surpassed with an even greater extreme. So, even though the 10-year Treasury note rising from the 1.32% low in July of 2016 to 2.75%, currently, which is an 109% increase, the frenzy for junk bonds continues.  The chart shown below, which is a recent B of A Merrill Lynch U.S. High Yield Option-Adjusted Spread, between Treasuries and Junk Bonds, is back in record low territory. It illustrates what usually happens after this occurs.

The spread between risk paid for owning corporate bonds versus Treasury securities has now dropped to 90 basis points, which is the lowest spread since March of 2009. Investors seem to be ignoring the action in the area of Treasuries, and seem to have great confidence in the future of the private sector. But as someone who is concerned about risk, one needs to be aware that corporate yields rise faster than treasury yields, and especially junk bonds. It would make sense to begin to avoid this area of the bond market.

Amazon continues to crush the brick and mortar segment of retail, with retailers such as Sears, Stein Mart, Bon-ton Stores, and Nine-West Holdings, on deck for a possible filing bankruptcy or some sort of restructure.

On the issue of the direction of the stock market in the short term, it would not surprise us if we are entering back into a volatile period for the market, moving forward. As we recently pointed out, investor positive sentiment had reached historical extremes in early January. Bloomberg recently reported the measurement of investor sentiment conducted by Goldman Sachs was in its highest extreme that it has seen since it started measuring it in 1991. That is a bit concerning for us, as it does suggest a higher probability that we have reached market highs or that we are near them. Additionally, it is becoming pretty apparent that the current employment environment is strengthening with employment numbers coming in better than expected and real wage growth is finally here. This increases the likelihood that the yield for the 10-year Treasury will hit 3%, and the Fed Funds rate, will grow significantly over the next year – Some would argue the Fed may raise the Fed Funds Rate to 2%, as Bill Gross recently suggested on Bloomberg Radio.

But, just to make things confusing, ECRI published their public article last week, that discusses " Average Hourly Earnings" and its recent increase, and emphasizes the cause for it. The AHE ratio, which is the total weekly pay to total weekly hours, increased due to a faster decline in weekly hours than weekly pay. They argue that on the surface it appears to be good news, but the truth is, in their opinion, that this is actually indicating an economic slowdown is ahead.


ECRI points out in their article, titled: Up is Down: Jump in AHE Growth Confirms Economic Slowdown, contrary to popular belief, such a slowdown in weekly hours worked is not a signal of an inflation upturn. And if the jump in wage growth pushes the Fed to be more hawkish, it could actually worsen the slowdown.

The chart above (posted in an article from Advisor Perpectives.com) illustrates that only once has a recession ended without the index achieving a new high, which was the (“double-dip”) two recessions that occurred back in the 1980’s. The recent article from Advisors Perspective.com, that discusses ECRI’s recent report, also points out that we've exceeded the previously longest stretch between highs, which was from February 1973 to April 1978. But the index level rose steadily from the trough at the end of the 1973-1975 recession to reach its new high in 1978. The pattern in ECRI's indictor is quite different, and this has no doubt been a key factor in their business cycle analysis. The take away from this is that it gives a historical argument that the risk of an economic downturn ahead is possible, which is contrary to the consensus that is out there.
We will see what lies ahead. As we have been stating previously, we were bullish on the equity market for all of 2017 and possibly through the first quarter of 2018, but entering into the second quarter of 2018 was a period of growing concern for us. This was based on a number of things including, length of the current bull market cycle, the record high levels of margin debt, record high levels of positive investor sentiment, and frothy equity valuations.
This coming week, we will have the release of 544 earnings reports. Additionally, there are very few economic reports which is typical after the employment situation is released. Those that will be released are not material economic factors. We expect that this will have a positive effect and the markets will experience a recovery rally this week.

Friday’s sharp decline was certainly unexpected by most market participants. After experiencing multiple days in January of panic buying, the markets were met with heavy selling for the first time in a long time as folks took profits and squared up positions ahead of the weekend.
With February starting off extremely weak, we are likely to see a very choppy pattern unfold this week. There is a chance, in our view, that we could see a rebound, but the market could experience one more drop before bouncing back into the range just mentioned.
However, the configuration does suggest that markets are likely to see a 6 to 8-week consolidation before they will be in position to resume the uptrend. While the probabilities point to higher prices down the road, volatility is likely to remain elevated over the next several weeks.

Best Wishes,

Zeller Kern Investment Committee