January 2, 2019

Saddam Hussein used an Arabic version of Whitney Houston’s “I Will Always Love You” as his campaign theme. That may be as unexpected a fact as 2018’s negative finish in the U.S. equity markets.

I have been openly bullish on U.S. stocks – and rightfully so – for a long-time, citing fundamentals and data. Approaching December, I was feeling bullish but with less intensity. The data still suggested U.S. equities were the best place to be. Yet now, as we conclude the worst December for U.S. stocks since 1931, I can say I was wrong, at least for now. Feeling wrong is a tough thing to say, but the beauty of my method is I look at data. If the price action doesn’t jive with the data, negative emotions can carry the day.

Let’s revisit the data. I’ve been committed to a bullish stance because of sales and earnings growth (regardless of whether or not earnings have peaked), record low taxation, record profits, record buy-backs (over $800 billion), and the hard-to-dispute view that the U.S. is best-in-show for global equity markets.

All that was not enough to fend off the naysayers. They cited peak earnings momentum and a potential for a global growth slowdown. I guess just a plain old “really healthy economy” seems awful compared to a “very-strong economy.” Along with fears of growing trade-wars, fed tightening, and a never-ending Mueller investigation, this seemingly-average “healthy economy” invoked the market’s boogey-man.

As I wrote last week, the preliminary findings of our study of the equity downturn points the finger of blame to ETFs. The theory goes something like this: Wealth managers are compensated by the size of assets gathered. Since the early 2000s, ETFs benefitted from huge asset growth. Passive investing became all the rage as “hedge funds are dead.” Outperformance wasn’t necessarily the goal anymore, especially in the wake of the 2008 financial crisis. Trying to outperform the bull market we’ve seen for almost 10 years seemed almost a waste of fees: just slap your money in an ETF, track your benchmark, and call it a day.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

No offense to wealth managers, but they became focused on gathering more assets and diverting them to passive vehicles, especially those with big incentive fees. As assets ballooned, a tipping point eventually came. Stocks stopped moving ETFs, and it turned the other way around: ETFs moving stocks. As time passed and more ETFs emerged with more assets flowing into them, we arrived at a crossroads in 2018.

The data I see paints a clear picture of the tail now wagging the dog: The ETFs are in control now.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Complicating matters, human traders became old-school. The new masters-of-the-universe are quant-finance or math PhDs who program increasingly efficient algorithms to trade the market on their own. Free from human emotion, their machines plumb the markets, hoovering up profits when conditions are favorable and reducing risk when they aren’t. This became a storm cloud gathering on the horizon that people would often think about, but less-often talk about, and hardly ever take action on.

As 2018 began, we got our first inklings of what could happen. Late January’s correction looks trivial compared with December, but it felt colossal at the time. The sudden drop seemed like a mad-scientist-designed roller coaster ride. When the dust settled, inverse ETFs bore the blame for the market meltdown, and some bore the shame of blowups. Some funds lost 90% or more of their value, triggering liquidations.

Once the bodies were carried away and the blood was mopped up last February, we rallied to new highs within six months.  “Buy the dip” continued to be the chant of the winners. That strategy was undeniably profitable for nine years, but as the years wore on, ETFs took up more space on the highway, and the overall traffic flow was being driven by more and more computers, not human drivers.

As the summer delivered new highs, financial advisors heard whispers of a growth slowdown. Using my neighbor as an example, he and I would rejoice in touting strong economic numbers, yet we began to diverge as he heard speakers discuss recessionary forces brewing. These speakers had few supporting metrics but they caused anxiety, nonetheless. Multiply my neighbor times the many thousands of advisors in the many thousands of branches across America. When August and early September came, we saw a notable slowing of buying.  As assets stopped flowing into ETFs, they also stopped flowing into stocks.

As stocks lost their underlying bid, the algo-traders went to work. They thrive on volatility and blown-out spreads.  When there was no bid for stocks, and no confidence left to “buy-the-dip,” the markets started to crack. When technical levels were depressed enough, model-ETF managers reached for their exit triggers and the dominos came cascading down. October was brutal for many funds. When November offered no positive respite, December brought liquidations.  Record assets flew out of ETFs, and as they were sold, the underlying stocks were also sold as hedges by dealers supplying liquidity.

Look for Today’s Hated Stuff to be the Bright Spots of 2019

As 2018 ends, it will certainly go down as a year of immense volatility. So, what does it mean for the future? Markets have a way of becoming lopsided in terms of how they trade. In the roaring 1920s, stocks were speculative instruments that toppled with extreme valuations. The 1990’s brought the dot.coms, with unrealistic valuations that eventually imploded; then housing valuations became unsustainable in 2007.

Today’s main difference is that companies are making money, the U.S. is prospering, and the economy is expanding, so this sell-off does not fit the speculative “bubble” narrative. Maybe some bomb in the system will emerge in the months to come, but my data says this was a technically-driven tipping point. Fear of a potential slowdown took the fire out of the eyes of the buyers, so the sellers dominated the day.

In past crashes, the further down prices went, the less investors wanted to buy.  Levels slipped below ETF comfort levels and the redemption deluge began. Unfortunately, market volatility may become the norm. Lulls speckled with stomach-churning “unprecedented” moves may become more commonplace.

In late October, I warned of an oversold market and expected a bounce. Markets rallied sharply thereafter. It wasn’t enough, however, and last week I highlighted extremely oversold conditions and said to expect another bounce. Last week saw the S&P 500 rally, so we finally have some green for the week just past.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

As the year ends, everyone I talk to is bearish. Traders are net long $1.2 billion of VIX futures and options (close to all-time highs). Both indicators seem to be a bullish setup for 2019. Funds must deploy capital into equities in the New Year. This should lift equity prices. So, where should we focus?

As market yields head lower, dividend growth equities should be desirable. New leadership may come from strong companies that grow their dividends. I believe China will outperform as well, and Financials should also catch a bid. In short, look for today’s hated stuff to be the bright spots of 2019.

As Rilke said: “And now we welcome the new year, full of things that have never been.”

About The Author

Jason Bodner

Jason Bodner writes Sector Spotlight in the weekly Marketmail publication and has authored several white papers for the company. He is also Co-Founder of Macro Analytics for Professionals which produces proprietary equity accumulation/distribution research for its clients. Previously, Mr. Bodner served as Director of European Equity Derivatives for Cantor Fitzgerald Europe in London, then moved to the role of Head of Equity Derivatives North America for the same company in New York. He also served as S.V.P. Equity Derivatives for Jefferies, LLC. He received a B.S. in business administration in 1996, with honors, from Skidmore College as a member of the Periclean Honors Society. *All content of “Sector Spotlight” represents the opinion of Jason Bodner*


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