Behind the Eightball, or Stuck Between a Rock and a Hard Place

This week we witnessed the return of volatility. Twice this week overnight S&P 500 moves eclipsed 1%. Daily ranges for the S&P, the difference between the lows and the highs of the day, averaged 2%. At writing, the S&P 500 is down over 1.5% for the week. Volatility is even more pronounced in Tech shares and small-cap companies. The Russell 2000, the small-cap index, is down over 12% from its highs on November 8^th. The Nasdaq 100 is down nearly 7% since its high on November 22^nd. Correspondingly, the VIX, the Cboe Volatility Index, is up over 67% since Thanksgiving.

While the Omicron variant is generating a lot of credit for the rise in volatility, I suspect that shifting Federal Reserve policy is having a greater impact. This week Chairman Jerome Powell finally admitted that they need to “retire the word, transitory” when referencing inflation. Now that the Fed admits that current pricing pressure is not temporary it seems clearer that they will not just be taking the foot off the gas pedal, but also applying pressure to the brake pedal.

Since 2008, the stock market has not fared particularly well without support from monetary policy. Unlike any other time in the past 13 years, the Fed is actually under the gun to act more swiftly. Fed policy up until now has not had much of an effect on inflation, consequently they haven’t had an immediate need to readjust policy. This time, as they say, is different. Much remains to be seen as to how quickly they taper bond purchases. But tapering bond purchases is just the tip of the iceberg. They will need to beginning raising interest rates and quickly if they are serious about addressing inflation.

For some time, now we’ve been warning about elevated valuations in the stock market. All signs are out there that rampant speculation is taking place. From meme stocks to bitcoin to online sports gambling, people are in love with the idea of getting rich and getting rich quickly. This is how bubbles inflate. If this is a bubble, we will find out shortly. I like to think of bubbles like balloons floating around almost searching for a sharp object to pop it. Once the balloon has been penetrated it wildly sputters around hitting every object in its path. At this stage, market emotions run in reverse. Where once every event or piece of data presented an opportunity to buy more, now every piece of news is a reason to sell.

When the Tech Bubble burst in 2000, seemingly without any identifiable cause, all the news became reflexively negative. The drawn-out election in November of 2000 was reason to sell. The terror attacks in September 2001, more reason. Finally, in March of 2003, the pain stopped, and the market began climbing again. The cause for the end of the carnage remains as much a mystery as to the cause for the beginning.

It’s uncomfortable to say, “I don’t know.” We are trained at school that not knowing is not a good answer. But if you ask me if this is the beginning of the end of the bull market I have to say, “I don’t know.” Rather than falling back on gut feeling or intuition, we ultimately have to rely on data for signals. We’ve frequently written about the advantages of momentum-based strategies. These strategies are based upon data analytics, they allow the data to dictate change rather than relying on behaviorally flawed intuitive powers.

Momentum-based strategies which seek assets that are outperforming will find suitable investments to best protect your money in times of stress. It may not prevent losses, or pain, but they have the ability to reduce losses. Binary choices between all in or all out leave us exposed to catastrophic positions of missing out on returns or staying in way too long. But investing is typically a lifelong process. We’re never really done until we are done. Once we accept that our time horizon matches our lifespan we can get a little perspective on the shorter term fluctuations.

Thanks for reading,

Zach and Dave

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