Last Week's Equity Selloff

October 18, 2018

Source: Bloomberg Source: Bloomberg

Historically, October has been a more volatile month, and this year has yet to disappoint. On October 10, the S&P 500 Index dipped 3.3%. The following day, the S&P 500 Index declined another 2.1%. As of October 12, those days are ranked the third- and ninth-worst of 2018, respectively. There were no major headlines those days, so why did the market selloff? 

A possible explanation could be interest rates. From the beginning of September, 10-year U.S. Treasury yields have risen more than 30 basis points (bps). In a recent speech, Federal Reserve (Fed) chair Jerome Powell noted that the Fed might need to raise rates more than expected to prevent the economy from overheating. Investors reluctantly came to realize that equity valuations need to be adjusted with higher interest rates. From October 1-11, the NASDAQ Index has underperformed the Dow Jones Industrial Average Index by 3.4%. To me, this is evidence of equities being repriced, since growth stocks are more sensitive to rising interest rates. 

Some analysis also blamed the systematic community, including Commodity trading advisor (CTA) funds, risk parity funds and volatility control funds – all algorithm driven multi-asset investment vehicles with combined assets over $1 trillion. I believe that CTA funds have shortened their equity length because the S&P 500 Index finished lower in nine out of 12 trading days before the selloff. As for volatility control funds, they probably did not participate in the selloff due to the prior suppressed realized volatility. However, it is possible that both the risk parity funds and volatility control funds would selloff if the realized volatility remains elevated. 

There are other uncertainties, however, which may have fueled the selloff, including the U.S.-China trade war, the U.S. midterm elections, an overly generous Italian government and rising oil prices. 

As seen in this week’s chart, when comparing last week’s event to February 2018, one difference is that implied volatility during last week did not explode as was the case in February. Markets did not panic over the selloff. One similarity both events share is that equity selloffs did not spread into the credit market. The iShares high yield corporate bond exchange-traded fund (ETF) only gave up 0.6% in the two days. Without seeing weakness in the high yield credit market, equity selloffs did not go much further.


Key Takeaway

After the world economy enjoyed a year of synchronized growth in 2017, we are in a very divergent 2018, with the U.S. leading the world and the rest lagging far behind. The October 10 and 11 equity selloff shows that future uncertainties are starting to take a toll on the U.S. market. Exemplifying their effect is the S&P 500 Index, returning on average -0.4% for the six months before midterm elections. Looking to the six months ahead, however, S&P 500 Index average returns are 12%.


Tags: Volatility | S&P 500 | CTA funds

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