December 26, 2018


I’m sure a lot of people are saying that word these days. It seems to be an appropriate utterance, but I’ve been using others words – like “abysmal” and “ugly” in the recent weeks of weekly reflections, but this week’s selling was also dreadful, terrible, and awful. Those were the Microsoft Word synonyms that came up for abysmal: One week, MTD, and YTD performance for the major indices are as follows:

Depending on how you are invested, this is catastrophic. The sector performance was also atrocious. The sad truth is that now we only have two sectors with positive performance for the year, and one is clinging on by a thread. Utilities are +2.2% and Healthcare is +0.2%. Opening my sector performance screen is like peeling back the bandage in the scene from Castaway; it’s gruesome and uncomfortable.

We all know this. So, the question is why?  We’ve gone from a period of relative optimism to extreme pessimism in a few short months. Talks of slowing global growth and a possible recession dominate the headlines. If there’s one thing that gets markets moving, it’s fear.

The news attributes this latest panic to global slowdown and the Fed. Parts of Europe are dipping into fear of a recession (Germany and Italy). But in the U.S., the data has been rosy. Plainly, we have hit peak sales and earnings growth momentum. But does this supposed slowdown (which we have no concrete data for) really warrant a -25% haircut from the highs, as we are seeing in the Russell 2000 (since 8/31)?

Clearly, my answer is “no,” as my tone has been bullish on U.S. stocks, even in the face of this drastic selling action. I have cited data, fundamentals, and some technical action that was indicative of a bottom. I was right for a while and the bounce I accurately predicted gave way to this recent disgusting plummet.

Many say we can thank Jerome Powell for the levee breaking last week. The rate hike we saw was expected, but less expected was the implied commitment to hike twice more next year. Even less expected (and more disliked) was his reference to “further gradual increases.”

“The Committee judges that some further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2% objective over the medium term.”

The issue was a future commitment to tightening and removing liquidity from the system. This was the last straw and caused the deluge of selling that came after.

We can also blame the government shutdown. We can blame the Mueller investigation seemingly getting closer to president Trump and potential charges. We can blame what we want in the headlines, but my belief is there is a clear technical catalyst and follow through. We should also be looking at ETFs.

The Role of ETFs in Creating Selling Panic Loops

Back in October, I wrote about how I saw the world of High Frequency Traders. These algorithmic trading firms use news as one of their inputs into trading decisions. When liquidity dried up on the bid-side of the market, they used bad news days as an opportunity to short into weak bids. This broke open volatility and began a domino selling effect.

I then wrote about how ETF model managers would eventually be forced to sell. When they need to sell hundreds of millions of dollars of a not-so-liquid ETF, they call up dealers (or interact electronically) and source bids. When dealers price a market where spreads are already widened due to heighted volatility, their bid/offer spreads widen. When they end up owning the ETF sold by the customer, they in turn must hedge by selling the stock components of the ETF. This pushes stocks down further.

The more I thought it through, the more I realized that ETFs may be causing the massive spikes in UI sell signals that we see, not vice-versa. This idea of the tail wagging the dog is what I’d like to discuss now.

As ETFs trigger sell points, I believe they actually drive stock action, especially on the down side. The number of ETF assets has grown dramatically over the years as well as the number of available ETFs. What we observed is that as the number of available ETFs and total assets they controlled ballooned, so did our signals counts. This was true for both ETF and stock signals.

As ETF managers execute redemption requests, the pressure on stocks is massively amplified. One stock may be in dozens or even hundreds of ETFs. At market pressure points, ETF dumping amplifies the selling of stocks. Furthermore, illiquid ETFs can have a major swing effect on stocks that comprise them.

I believe that as assets fly out of ETFs, the forced selling started by model managers, in-turn started by HFT firms taking advantage of what was believed to be a temporary absence of buying, the pressure on stocks is rocking the entire market, and thus world markets.

While this theory may seem a bit far-fetched, we have begun work on an in-depth study which will become a larger report. So far, the preliminary data supports that thesis. So, for now, I’m going to go ahead and blame ETFs! Lipper came out Friday and said that month-to-date ETFs outflows are the largest on record since record-keeping began in 1992.

I also believe that it’s important for long-term investors to keep a cool head. We’ve seen irrational markets before. I’ve watched investors throw in the towel at the worst possible times. The herd is rushing for the exits. But know that if market sentiment can turn from positive to negative on a dime… it can also just as quickly change from negative to positive.

It may sound crazy, but I still expect a big bounce. The breadth of the market is terrible, with just 9% of S&P 500 stocks trading above their 50-day moving averages as of Thursday. Surely that number is lower now. Naturally, the S&P is in extreme oversold territory by many measures. Its 10-day advance/decline line has dropped to its lowest level in at least a year. The trailing 12-month P/E ratio for the S&P 500 has a 16-handle on it. That’s the lowest in multiple years. The dividend yield on the S&P 500 is around 2.2% while the 10-year bond is below 2.8%. Those two keep getting closer, which is bullish for stocks.

Finally, our MAP-IT ratio is cratering closer to 25%, which is oversold territory. We are at 26.9% as of Friday.

One last thing… we took a hard look at how extreme sell signals correlate to forward returns of SPY. The future returns for the market seem quite promising after we witness abnormally high sell signals. Of the 48 days that displayed unusual sell signals of the 400 or more since 2000, the market was positive three months later 70% of the time. If you had patience to wait 24 months, 76% of the time the market was higher, with an average return of +27%. (Naturally, the financial crisis of 2008 skewed the results.)

Rest assured, this volatility will pass. I believe we’re 90% done with the sell-off in prices, and 75% done with the sell-off in terms of time. That means we’re close to a bottom. The bounce could be swift and fierce, but I realize that sitting through it and waiting for it to end is tough for everyone involved.

I know the volatility is brutal (another good word) but hang in there… The end is in sight.

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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