Markets are a reflection of economic and political events on a domestic and global basis. When it comes to the stock market, since the sell-off that took the S&P 500 11.5% lower at the start of 2016 because of slower growth in China and a massive correction in the domestic Chinese equity prices, the market has been a one-way street higher. Stocks became Teflon assets as they only paid attention to supportive news and ignored any bearish influence. The S&P 500 rallied by over 38% from the February 2016 lows to the recent July/August 2017 highs. Other markets like the Dow Jones Industrial Average and the NASDAQ posted even greater gains appreciating by 43.5% and 52.6% respectively over the period.
Enthusiastic optimism enveloped the equities world as company valuations continued to rise on the back of a constant flow of buying. Savings and investment capital found its way into the stock market as interest rates remain near historic lows. The prospects for dividends and capital appreciation offered by stocks have been a magnet for money and have sent the major indices to all-time highs. It seems that investors have ignored any data or news that might be bearish for equities. Rising U.S. interest rates did not slow the rally in stocks, and the announcement of balance sheet normalization by the Fed, which amounts to quantitative tightening, did not cause any significant correction in the market.
Even the ongoing divisive political landscape in the United States where the President has not be able to convince a House and Senate from the same political party to enact legislation to fulfill his campaign promises have not stood in the way of equity appreciation. However, late last week the music appeared to stop for stocks, and they fell in the biggest corrective move since May. This time, political events on the domestic and international front have driven stocks lower, and a significant correction could be just getting underway.
A big sell-off in August
On Thursday, Aug. 10 selling hit the stock markets, and the three major indices experienced the greatest decline since May. The DJIA spent one week above the 22,000 level. Source: Google Finance
As the short term chart highlights, the most closely-watched index fell by 204.69 points on Aug. 10, a decline of 0.93%. Source: Google Finance
The S&P 500 dropped by 35.81 in last Thursday’s session and moved 1.45% to the downside. Source: Google Finance
Meanwhile, the high-flying NASDAQ Composite dropped the most when it posted a 135.46 point or 2.13% loss on the session. A combination of events caused the major equity indices to drop and also caused a huge upside correction in the volatility index that measures the market’s perception of future price variance.
The VIX explodes
There has been an explosion in the trading of derivatives products over past years. The chief determinate of options is implied volatility. There are two types of volatility measures in markets. Historic volatility is the metric that measures the past price variance of a market. Implied volatility is the metric which is a consensus of the market’s perception of future volatility. The VIX index is a trading vehicle that measures implied volatility, and it forms the basis for pricing in equity options. The VIX had been trading at some of the lowest levels in years over recent months. Source: CBOE
Over the past month, the VIX had traded in a range from under 9 to over just over 12. Most of the time over the period, the volatility index spent its time trading in a range around the 10 level. The fall to 8.84 on July 27 was the lowest level in over ten years in the index. The volatility index was trading at historic lows as the equities market powered higher to new records.
However, on the day that the three indices moved to the downside, the VIX exploded to over 16, the highest level May. Before that peak, you have to go back to election night for a higher reading on the market’s perception of volatility. The VIX closed last week at 15.51. On Aug. 7 the index was under 10, and by Aug. 10, the index had appreciated by more than 50%. Fear and uncertainty had gripped markets pushing the volatility index higher and assets that tend to perform well during times of a flight to quality rallied sharply.
Precious metals take off to the upside
Gold and silver tend to rally during periods of turbulence in markets, and they took off to the upside late last week. Source: CQG
As the chart of COMEX gold futures highlights, the price of the yellow metal rose from $1257.10 on Aug. 8 to highs of $1298.10 on Aug. 11. Gold moved 3.26% higher. After a brief pullback it is back up and close to those highs. Source: CQG
The price of silver rallied from $16.095 on Aug. 7 to $17.24 on Aug. 10, a rise of 7.11%. Like gold, silver pulled back and traded to $16.56 this week but moved back above the $17 per ounce level after the brief correction. Additionally, two other markets that are often the beneficiaries of flight to quality buying have rallied since Aug. 7. The Japanese yen has strengthened, and U.S. government bonds have moved to the upside. The dollar tends to rally during periods of uncertainty, but the greenback remains close to recent lows at 92.39 on the September dollar index futures contract.
There are two reasons that stocks are on shaky ground, and there is now a flight to quality under way.
North Korea poses a real and present danger — one crisis after another
North Korea is now a nuclear power with the ability to strike at not only their neighbors in Japan and South Korea but the continental United States. Last week, the rhetoric between the rogue Kim regime and U.S. President Donald Trump ratcheted up many notches as North Korea threatened to fire missiles at Guam. In response, the President told North Korea to behave and warned of dire consequences saying the U.S. military is “locked and loaded” and prepared to respond to any more provocative actions by the Asian hermit nation.
The United States had not experienced the current level of nuclear threat since the Cuban missile crisis in the early 1960s. However, that crisis was averted as both the U.S. and Russia understood the concept of mutually assured destruction in the case of a nuclear war. The United Nations recently voted unanimously for sanctions on North Korea with Russia and China uncharacteristically voting for the resolution. However, the North Koreans have since backed down on their promise to fire missiles at Guam by the end of August. Just as one crisis abates, another tends to start these days. On Wednesday, CEOs resigned from the administrations business councils blaming the President’s response to the Charlottesville violence last weekend. On Thursday, terrorism struck in Barcelona, Spain.
Infighting in the Republican Party will lead to no legislation
The other event that has weighed on stocks is a burgeoning feud between Senate Majority Leader Mitch McConnell as well as other prominent Republicans, and President Trump. The Leader of the Senate has taken the President to task for his tweets and expectations that the legislative body would work quickly to approve legislation fulfilling his campaign promises. The President fired back with criticism about the inability to repeal and replace the current health care legislation and the lack of forward movement when it comes to other initiatives. The market has become worried that tax reform will suffer the same fate as health care. Even though both men are from the same political party, a rift seems to be growing wider between the executive and legislative branches of government in the United States.
The bottom line is that domestic political factors and geopolitical events are now weighing on equity prices and fear and uncertainty about the future are threatening markets with a period of risk off and a flight to quality assets. I expect that volatility in markets across all asset classes will become the norm rather than the exception over coming weeks and perhaps months as one crisis has led to another and this pattern appears to be continuing. The DJIA closed at 21,750 level on Thursday, Aug. 17. The S&P 500 was at 2,430 and the NASDAQ was trading at 6,221. Even though the equity markets recovered in the days following the Aug. 10 sell-off, by the close on Thursday, Aug. 17, all indices were below the lows of Aug. 10 as politics continue to weigh on markets across all asset classes.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.
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