This guest commentary was written by Mike O'Rourke of JonesTrading. This piece was originally published on 7/27.
Today was certainly an interesting day. During the entire overnight session through to midday today, the S&P 500 futures traded in an extremely tight 20 basis point range. At that point, the release of a sell side macro call highlighting similarities to 1987 prompted selling in the equity market.
This occurred upon the heels of a couple of legendary investors highlighting significant risks in the current market environment. This sparked a market reaction. The Nasdaq 100 dropped 2.4% over the span of an hour. The S&P 500 dropped nearly 1%. In this low (almost no) volatility environment when the S&P 500 was down 50 basis points, it felt like 500 basis points.
The Fab 5 names that comprise nearly 14% of the S&P 500 and almost half of the Nasdaq 100 all dropped 2.5% to 4%. In typical fashion for this tape, after an hour of selling, the market entered "buy-the-dip" mode.
This market has a reputation of being one that only rises and rarely falls. It has been well advertised that the S&P 500 has not registered a 5% pullback in over a year. We have highlighted the fact that there have only been 4 trading sessions year to date where the S&P 500 has closed up or down 1 percent or more. That is only 3% of the time as opposed to the 89 year average of 24%. We have also noted that the 50 basis points daily changes are occurring at historically low levels. The S&P 500’s negative reversal today was just shy of 1%. At its worst level, the index was down 0.72% but when the afternoon rally took hold, it settled with a small loss of 10 basis points.
As today’s S&P 500 trading range fell short of 1%, it prompted us to measure how many days the S&P 500 trading range exceeded 1%. The results are even more staggering than the daily change readings. Thus far in 2017, there have only been 6 trading days in which the S&P 500 has registered an intraday range of more than 1%. That is only 4% of the time, which compares to a historic average of 50% dating back to 1982 (chart below). When it comes to days registering a 50 basis point trading range, it has only occurred 46% of the time, compared to a historic average of 89% (chart below).
'rampant complacency, lofty valuations and speculative excess'
This environment has many similarities with previous levels of dangerous market extremes - rampant complacency, lofty valuations, expensive leadership and speculative excess. There are several aspects unique unto itself. The entire equity market is expensive across the board, it is not simply one sector. There are few to no pockets of value.
There have been 6 years of multiple expansion far outstripping earnings growth, all amidst the slowest US economic expansion in history. Other assets are historically expensive as well, most notably bonds. Remarkably, the low rates of these instruments (which are being manipulated by every major central bank in the world) are often used as the rationalization to pay very expensive prices for equities.
Consider this, when the S&P 500 bottomed in 2009, its market cap was approximately $6 Trillion. Since then, the Federal Reserve has increased M2 money supply by more than $5 Trillion and removed another $3.5 Trillion in assets from the market.
That is a remarkable swing.
Although Chair Yellen has repeatedly warned of the risks of keeping policy too easy for too long, nearly a decade did not seem too long to her. We are left with an environment where policy has been so easy that financial conditions continue to ease as the FOMC tightens. They have been lax for so long that the market as a whole often does not react to fundamental developments.
The Fed sees the monster it has created, but does not know what to do about it. This is not a business of guarantees, but there are two things in which investors can be confident, volatility will not remain this low and financial conditions will not remain this easy. Just like every other episode in the market, this one will pass as well.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor research note written by Michael O'Rourke, Chief Market Strategist of JonesTrading, where he advises institutional investors on market developments. He publishes "The Closing Print" on a daily basis in which his primary focus is identifying short term catalysts that drive daily trading activity while addressing how they fit into the “big picture.” This piece does not necessarily reflect the opinion of Hedgeye.
