2018 Forecast: Why This Year Feels Terrible for Markets
By: Steve Smith
After traveling up by some 10 percent in January, then dropping precipitously in February, only to swing wildly in March, the S&P 500 is now basically, exactly unchanged on the year. Essentially, no harm, but also no gain. So, why has it felt painful?
Over on Bloomberg, Barry Ritholtz explains Why 2018 Feels So Terrible for Markets.
Last year was unusual in many ways for financial markets. When expectations for how events normally unfold become challenged by data way outside its normal range, it is easy to imagine the world has gone mad. A science-fiction genre exists where the protagonists have jumped to (or awoken in) an alternative world. Think “The Man in the High Castle,” the “Star Trek” episode “Mirror, Mirror,” and “It Can’t Happen Here.”
To this group, you can add a new title: “Outlier 2017.” I can imagine the sonorous baritone voiceover during the opening scene: “It was a year filled with aberrations.” To wit:
- Above-average U.S. market returns;
- Record corporate profits;
- Even higher returns overseas, especially for U.S. investors when priced in dollars;
- Record-low market volatility;
- Record-high political volatility;
- Fed funds rates near record lows;
- Market interest rates near record lows;
- Below-normal inflation; and
- Low bond yields.
But those unusual data points are ephemeral, as statistical outliers always revert to historical means — eventually. And so that is what we are living through this year. Indeed, if 2017 was a year of eccentricity, then 2018 represents a return to normalcy.
What has changed? Combine above-average returns, the passage of time, and a very specific technical event, and you create the right environment for reversion. The U.S. equity markets have risen for nine consecutive years, and during seven of those nine years, it rose by double-digit amounts. It’s easy to see markets getting a little ahead of themselves, and needing to digest those gains. Those who look at the longer market cycle after this fantastic run wouldn’t call a quarter or three of sideways action unexpected.
Why did volatility suddenly return? Consider that long run of gains by the broad indexes. Active traders and hedge funds found a profitable trade in making highly leveraged bets against volatility. Of the dozen or so exchange-traded funds and exchange-traded notes designed to make this bet, much of the capital was concentrated in just a few of them. The precise factor that precipitated the blow-up of these products is unknown.
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