By: Dividend Sensei
Another day, and another big loss in the markets. Times like these may try investors’ souls, but at the end of the day they are necessary to ensure a true bubble doesn’t form and then lead to a crash. But what exactly causes such crazy volatility as we saw on Monday, when the markets saw the third flash crash since the financial crisis. The one that saw the Dow Jones fall 900 points in about 10 minutes and caused even the bluest of blue chips, such as AAA rated (higher than US Treasury) Johnson & Johnson to be down 10% at one point?
Well there are two answers to this. First, not surprisingly, there was a major catalyst that popped the market’s “goldilocks economy” euphoria bubble. Specifically the idea that economic growth could accelerate, but that stagnant wage growth would keep inflation low, and thus keep interest rates from rising. As Warren Buffett has been saying recently, stock valuations are not that high, IF interest rates stay where they are. But if they rise 1% or even 2%? Well then investor discount rates will rise and earnings multiples will fall.
In this case the catalyst that triggered the correction was the January job report, which showed continued strong job growth, but also wage growth spiking to +2.9% YOY. It also saw an upward revision of the December figure from 2.6% to 2.7%. That means that, at least for now (barring future revisions), wage growth has looked like this:
- November 2017: +2.5% (average for 2017)
- December 2017: +2.7%
- January 2018: +2.9% (highest in 8 years)
Theoretically if wage growth gets too high (due to a tight labor market and employers having to pay more to hire or retain qualified workers) then corporate profits will fall, which is bad for stocks. Or companies can pass on the higher labor cost as higher prices, which causes inflation. Higher inflation means that bond markets will demand higher yields on risk free Treasury bonds, which is what sets long-term interest rates and affects corporate borrowing costs. Higher borrowing costs eat into profits and slow growth, and are thus bad for stocks.
In reality of course, things are more complicated than the bumper sticker “theme of the day” mentality that Wall Street loves so much. For example, core inflation as measured by the Fed’s favorite inflation metric, the core PCE deflator, continues to be stubbornly low.
Note that core PCE has very rarely actually achieved the Fed’s official target of 2.0%, but has been cyclical. A few months ago it hit a local minimum of 1.4% and is now sitting barely above that at 1.5%. Could higher wage growth lead to more inflation? Sure, eventually, but keep in mind that we have no idea when it will happen or how fast. That’s the trick to understanding market freakouts like this.
They are not so much triggered by interest rates hitting a certain level, but by the speed of the increase, in other words, volatility. Volatility tends to beget volatility, because in today’s complex financial world investors (mostly large speculative institutions like hedge funds) can, and do, bet on everything under the sun. That includes buying derivatives like futures based on things like interest rates (or even stock market volatility itself). So when one of these metrics spikes too much in one way or another, things can get very exciting, very fast. On Monday it’s believed that certain options contracts, traded by algorithms, caused the flash crash.
Of course, machines trading blindly based on arbitrary sell signals (like Dow breaking 25,000) are only the cause of short-term flash crashes, and prices usually recover very quickly, as we saw on Monday. The kind of slides we’re seeing today, and that causes so much angst (grinding losses) are purely the result of another fear and maybe the huge popularity of passive investing.
For example, the SPY, the world’s most popular ETF has recently seen it’s largest fund outflows in history, (though not on a percentage basis). The problem is that index funds, such as SPY, are totally blind to valuation, because they are market cap weighted. This means that when investors buy SPY, their money is used to create new shares that then get invested into the largest components of the S&P 500, such as Boeing, Apple and Microsoft.
This means that the most popular stocks can get even more popular, as investors exciting to join the party via passive ETFs like SPY end up buying at any price, and thus sending prices soaring to dangerous valuations. However, this virtuous cycle then reverses in a correction, because the money flowing out of ETFs today are being taken out of shares sold in those same high-flying stocks. This is why Boeing fell 6% on Monday (flash crash day) while the S&P 500 was only down 4%, because volatility of the biggest index names ends up being increased when too much money flows into or out of ETFs.
But guess what? Boeing and Johnson & Johnson are still the same great companies they were before. This means that you can use flash crashes, and corrections in general, to buy the same great companies, but at much better prices. In fact, back in the first flash crash (May 6th, 2010), Procter & Gamble fell from flat to -31%, and then back to flat, all in a 5 minute period. Granted most of those trades were later reversed, but trades from the flash crashes of 2015 and 2018 were not. In other words, if you are lucky enough to witness a major machine trading panic then grab some quality shares, at truly outrageously low levels.
Not that I’m advocating buying Boeing or JNJ right now. They were both highly overvalued before the correction, so I’m personally waiting for their yields to hit 3% before I buy them (might have to wait until the next bear market). So while I wait for that, (and the next recession that likely causes it, which might be 2-3 years away or longer), I’m buying off my ultra value list. That list is now at 31 great, undervalued dividend stocks and rising by the day (I update the list once a week).
The bottom line is that volatility is caused by several factors, all building on each other in a grand symphony of heightened emotion, blind fear, and irrational human (and machine) behavior. So since you can’t change the fact that volatility is an unchangeable constant of the markets you may as well profit from it.