Last week, it looked like the raging bull market in equities came to a screeching halt.
Don’t believe it. The equity bull market only hit the brakes because it drove full speed into a real wreck: the bond market.
There’s no mystery to it.
It’s not time to worry and definitely don’t panic; there are two sides to this story.
There’s some good news and there’s some bad news. I’ll give you the heavy stuff first.
The bad news is that there’s more to come; markets aren’t done falling.
But the good news is that stocks will self-correct, and there’s lots of money to be made as markets adjust.
Here’s what happened, what’s next, and how to play this opportunity for profit…
The Bond Market Just Ran into a Wall
It’s pretty obvious how we got here.
Since 2008, central banks have flooded global financial systems with more than $14 trillion of funny money. All that money went to bail out insolvent banks, stabilize them, and eventually flush them up with profits so core elements of the financial system could support economic growth.
It worked! In the process, besides the trickle-down growth that economies would eventually enjoy, the majority of central bank liquidity would far and away be parked in bond markets and equity markets.
Why?
First, money went into bonds because interest rates were going to be driven lower and lower (even into negative territory). Driving interest rates lower and lower caused bond prices to keep rising higher and higher, which is the only reason investors would buy negative-yielding government bonds. As central banks drove rates further into negative territory, those ugly bonds rose in price.
Then, starting quickly in 2009, money went into stocks. Interest rates were low, so the yield on fixed-income investments was unrewarding. Equities, starting with dividend yields on stocks, were more attractive, and recovering economies would benefit corporate earnings and stock prices.
It all worked. Bond prices rose handsomely and equity markets soared.
But as the legend goes, Icarus flew too close to the sun.
As if no one was watching the effect that was clearly visible, the economic growth (which drove unemployment down relentlessly and, as of Friday, showed some decent wage growth) suddenly ignited some inflation.
We haven’t suddenly turned some corner and are now facing stagflation; what’s happening is healthy.
Wage growth notched 2.9% growth in January compared to a year ago. That’s not surprising in the least. Job growth has been increasing for 88 consecutive months, and investors are surprised by some healthy wage growth all of a sudden? It’s crazy.
It’s good for the economy that people are working, and good for consumption, production, and profits that wage growth puts more money in the hands of working Americans.
There’s no crazy inflation, no stagflation, no glaring red lights pointing to trouble ahead. There’s just healthy growth.
The Fed’s been trying to get inflation to 2%; they may be on the verge of finally getting close, maybe. The CPI growth rate in December was 0.1%. For all of 2017 it was 2.1%, and that’s with energy jumping higher in the latter half of the year.
That’s what the Fed wants.
But there’s no reason to panic over inflation pressure because those are the “all items” CPI numbers.
However, just because there’s no reason to panic doesn’t mean that people won’t.
What Happens Next?
Everyone has always known free funny money wouldn’t be forever. We all knew that quantitative easing would end and rates would eventually start ticking up.
What has panicked investors is the speed at which the rate on the U.S. Treasury 10-year bond has moved. It’s up to 2.85% on Friday from only 2% in September.
That’s a 42% rise in the interest rate benchmark.
Still, that’s just a reflection of bond-selling ahead of the Fed’s potential rate hikes in 2018.
The cost of money in the economy hasn’t risen much at all. It will rise as the Fed raises the fed funds rate, but there’s so much money in the system, small increases in the fed funds rate won’t translate into the rapidly rising borrowing costs.
There’s just too much money in the system and not enough loan demand to inflate borrowing costs.
In other words, this is a bond market sell-off leading to stock market profit-taking, not a stock market crash.
The reason stocks are moving in lock-step with bonds right now is that low volatility across asset classes led to a huge uptick in “correlation.” Correlation is the relationship asset classes have to one another. If there’s a lot of correlation, asset prices generally move in the same direction, which has been up.
Correlation is the highest it’s been in five-and-a-half years.
A lot of trades and investments are “crowded.” Investors are all betting the same way. So when one asset class (bonds) takes a hit, correlated assets (especially stocks) take a hit.
One serious manifestation of correlation is the headlong rush over the past two years and counting into “passive” funds built around equity benchmarks like the S&P 500, the Dow, and the Nasdaq Composite.
That’s a whole other level of correlation most investors don’t even know has been building.
Profit-taking by passive investors could lead to the leadership stocks being sold and benchmarks falling, leading to more selling when stops are hit.
The only worry investors should have is if index selling leads to successive rounds of ETF and passive mutual fund selling, which could lead to more negative feedback loop selling.
Barring that, robust profit-taking will turn into some heavy selling by “risk parity” funds as volatility rises. That will eventually dislocate correlated asset classes and drive seriously panicked big investors back into government bonds, which will arrest their fall and stem the tide markets are facing.
Knowing this is all well and good, but it means nothing if you don’t know how to play it.
Luckily, I know what this is the perfect opportunity for.
Here’s How You Turn Others’ Panic into Profits
The opportunities here are to pick up stocks you want to buy, especially the big, healthy, growth-oriented stocks that have been rising because their profits keep rising.
Investors will always pay up for growth, and some of the big tech darlings and industrial stocks that get hit on profit-taking here will be great buys.
The easiest way to play them is by selling put options on them.
By selling put options on all your favorite stocks and all the stocks you want to own, you collect a ton of money in a falling market (because puts become expensive and you’re selling them for a fat premium). However, if the market keeps falling, you could get “assigned” on the puts you sell.
That means you will have to buy the stock at the strike price of the puts you sold, which is excellent if you want to own those stocks at lower prices than where they are today.
If the market keeps going down, I’d keep selling puts and collecting that premium and would be happy adding to the stocks I want to buy anyway.
But (and this but is a good one) if the market bounces back, you get to keep all that free money you collected from selling panicked investors expensive puts.
That’s the way to play this bond-led, correlated markets sell-off, before it all self-corrects and stocks get back to climbing higher.
— Shah Gilani
Source: Money Morning