Submitted by Nicholas Colas of DataTrek
"Someone Always Knows", DC Edition
What happened on Thursday? We really don’t think it was tariffs – those have been in the public domain for days. Rather, we believe the market has a very unhealthy dynamic going at the moment. Washington policy is critical to market direction, but the information asymmetries there are profound. No one wants to buy the dip if a real seller with better DC sources caused it.
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We will go out on a limb and say that Thursday’s awful US equity market price action was not primarily a function of the new tariffs against China. These have been in the news for days. Yes, there may have been some hope that this cup might pass from us in a last minute compromise. If so, that was a misguided aspiration: President Trump has proven money-good on sticking to his major campaign promises.
It may have been the news that John Dowd, the president’s lead personal lawyer, was stepping down from that position. Even though he is a prickly character by nature and vocation, Dowd’s central advice to Mr. Trump had been to cooperate with Robert Mueller in his investigation. Dowd’s departure likely means the gloves are off, and the nation will witness yet more conflict between a sitting president and a special counsel. That is not an especially equity-friendly scenario, likely to further spook the horses.
In the end, however, this current bout of market volatility is lashed to an age-old Wall Street tenet: someone always knows more than you. Washington DC has become as leaky as Williams Sonoma’s finest colander, and every major hedge fund and money management firm has their sources of incremental information there. It is their job to know what’s happening next, and we must assume that they are effective in that role.
This information asymmetry between “Smart money” and everyone else has two important features. First, since what happens in Washington clearly and profoundly impacts stock prices, information on future government policy is hugely valuable. Second, to quote Gordon Gekko, “If you’re not inside, you’re outside.” And most of us are outside.
When I see days like today, my first and only thought is “What does that trader hitting discounted bids think they know?” Clearly plenty of other investors wondered the same thing but could get no clear edge on an answer. Hence, volume was lighter than you would expect on a big down day. Investors weren’t selling, but nor did they want to step in front of some near term negative catalyst.
You can also tell traders and investors were caught out by looking at what has happened to implied volatility in the options market over the past 30 days. We look at these “VIX of” data points every month and pulled the data through yesterday (i.e. pre today’s selloff). Our process: examine the pricing of implied volatility for options tied to popular exchange traded funds that track S&P sectors, small and mid cap indices, and similar important asset classes. This is the same math that calculates the CBOE VIX Index itself.
A few points on what this analysis shows:
- The VIX had fallen from 20.0 to 17.9 over the month ended yesterday (the 21st). Today, it closed at 23.3, the 7th highest close of the year. As with equity prices, whatever jacked up the VIX was not broadly known on Wednesday. Options traders tend to have sharper pencils, so this is important.
- The “VIX of” every S&P 500 sector except for one was down 4-21% over the same month-long period. No prizes for the outlier: it was Tech, where its “VIX” rose by 9% for the month ending Wednesday.
- Both investment grade and high yield corporate bonds likewise saw lower “VIX” levels in the past month, to the tune of a 4% and 30% decline respectively. No surprise therefore that high yield had a tough day today, down 0.6%.
- The general sense of “February wasn’t so bad… The worst must be past us” travelled to both Emerging and Developed non-US equity markets as well. The “VIX” of those asset classes were down 6% and 16% respectively over the month.
Our key takeaway here: Washington is going to dominate market action until Q1 earnings season kicks off in a few weeks. That’s a problem because of the information asymmetry we highlighted. Smart traders/investors always assume someone smarter is in the crowd with them. When markets take a tumble, few will be brave/foolhardy enough to step in and save the day.
On the bright side, this dynamic will eventually run its course. It just isn’t likely to be tomorrow.