Crash and Opportunity – February Market Update Posted on February 13th, 2018
February Market Performance

The market experienced quite a shock in the opening weeks of trading of February, pulling back into correction territory within a matter of days. At the bottom, the S&P 500 briefly gave back all its gains since last October. As of writing, most indices remain in the negative for 2018 though the market remains highly turbulent and undergoes large swings every day.

After a very strong 2017 and an even stronger January, it seems the market was stretched too tight, and conditions conspired to push it over a tipping point into a correction. Analysis of the events surrounding this pullback seem to indicate two technical factors that initiated and then accelerated the downturn. The first is worries about a higher interest rate environment, while the second was a glut of traders unwinding highly leveraged positions, especially those shorting volatility.

With the economy seemingly in full growth mode, investor attention has begun to turn towards interest rates. In January, while the Federal Reserve did not raise interest rates, their statement was interpreted by some as hawkish in tone, suggesting more aggressive rate hikes to combat future inflation. This outlook was bolstered by employment data showing wage increases in January, an indication of growing inflationary pressure.

By the beginning of February, these inflation worries blunted the market’s upward momentum and caused a spike in bond yields. It is believed the spike in bond yields in anticipation of higher interest rates is the catalyst that pushed the market over the edge. With the market already having moved so high and so far without a real pullback, the pullback started off on a steep decline.

The decline was accelerated due to the second factor we mentioned. The extended bull market has spurred the creation of various instruments to try and profit from low volatility, the most infamous as of now being the XIV, which has been a very profitable trade. Unfortunately, in the current downturn, these highly leveraged instruments can make huge sudden moves. The aforementioned XIV lost over 80% right at the beginning of the current downturn, resulting in devastating losses for those invested. Unwinding these trades further elevated market volatility, creating a vicious cycle that caused the VIX to explode up to 50, and drove the market down to a 10% correction.

After plummeting through various round number and technical support levels, the S&P 500 bounced off the 200 day simple moving average and has regained some ground. As of the time of writing, the S&P 500 is still 7% down from the high point in January and remains negative for the year.

Market Outlook

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So where does the market go from here? From a historical perspective, the average correction sees a market drop 13 percent, and takes approximately 4 months to regain its ground. If this is a turnaround into a bear market, however, the drop we’ve experienced is just the start, and the market will give up more ground in the coming months. Based on the factors precipitating the pullback, chances are that this will ultimately be a short lived correction, and the market should begin regaining ground within the next couple months.

With economic data remaining strong, there does not seem to be a fundamental basis behind the pullback, leaving just technical factors driving market movement during this correction. This becomes more apparent when we look at how the market has moved during the correction. At present, the major stock indices have fallen back in line with their 2017 trends.

Zooming in further on the S&P 500, the 90 day and 200 day moving averages become apparent as technical levels that line up pretty squarely with the 2017 trend. At the bottom of the plunge on February 9th, the S&P 500 briefly dropped to the 200-day moving average before rebounding into the weekend. On the way back up, the index met resistance at the 90-day moving average at 2656.

Based on these technical factors, it is unlikely we will see a further break below the 200-day moving average and the 2017 trend. We still may see some further turbulence and another retesting of the low levels as investors and traders continue to unwind risk. A similar situation exists on the upside; the resistance from the confluence of the 2017 trend and the 90-day moving average will likely prove a hurdle for the rebound. In all likelihood, the market will settle into an uptrend that takes up to a couple months to regain their highs.

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The correction has hit the Lockbox portfolio very hard. While our positions were far enough to not be overrun by the market directly, the speed of the decline and the incredible expansion of the VIX caused severe overruns of our risk thresholds. We were forced to close positions and reduce our risk exposure, locking in losses in the neighborhood of 20%. This is not a loss we can make up in the time remaining for the month and February will be a month in the red.

Locking in these high losses is painful, but is necessary in order to free up the fund to take advantage of the current volatility. Lockbox trades on volatility, and the current elevated volatility will give us the opportunity to ramp up cash flow and maximize return. We have been in this position before, most recently in August 2015 when the devaluation of the Chinese yuan dropped the market and gave us a 17% beating. The heightened volatility after that plunge accelerated our returns and we regained the lost ground over the next 7 months.

While the worst is likely over, turbulence will remain and we will likely revisit the low again as the market tests the support level at the 200-day moving average. Volatility should stay high through the rest of February, giving us an opportunity to jumpstart our cash flow. Over the next several months, volatility will trend back down as the market stabilizes, but will remain elevated compared to the record lows seen in 2017, and enable us to generate higher consistent returns throughout 2018.

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