Don’t Panic, the Bull Market Isn’t Over Yet
I have to admit, this past Wednesday gave me a bit of a jolt.
All of the major indices were down sharply, as investors began to get nervous about news from Washington, D.C. The S&P 500 suffered its largest one-day drop since September. Meanwhile, the Dow Jones Industrial Average lost 1.78%, and the Nasdaq gave up 2.57%.
All of a sudden, it seemed, investors were waking up from a haze of complacency. After all, prior to Wednesday, volatility in S&P 500 options (measured by the VIX) had reached a 24-year low. That’s usually a sign that the market is about to crash.
Would this be the day the shoe finally dropped and marked the end of the bull market?
Interestingly, the catalyst for Wednesday’s drop wasn’t due to any revelations from Washington about tax policy, infrastructure spending, or the like. Rather, it was because of new reports about President Trump, the Russians, the FBI and the like.
I won’t get into further details — chances are, you’ve already formed your own opinions. But if you’re like me, you’re waiting until more information comes out before forming any judgments. Yes, things could get ugly — more bad news could come out that could necessitate a rethinking of your investment approach. The opposite could also be true.
In the meantime, if you’re reading this newsletter, you’re here to make money.
That’s not to say Washington shouldn’t affect your investment approach. It should. But it’s important to keep in mind what really moves markets, above all else.
I’m talking about interest rates.
I know, I know… It’s not the sexiest of subjects. But take a look at what Amber Hestla had to say about this to readers of her premium newsletter, Income Trader. By the time you’re finished, I think you’ll agree that her clear-eyed thesis is far more relevant to the market than anything you’ll watch on cable news.
“Based on futures markets, we can estimate the probability of the Federal Reserve actions for the next few months. For now, traders believe there is an 83% probability the Fed will increase short-term rates in June. If they do, that would raise the target for the fed funds rate to 1%-1.25%.
In recent years, interest rates haven’t been meeting their historical purpose. In the past, interest compensated the borrower for lending money. Standard financial theories tell us the level of compensation should be influenced by three major factors: return on your investment, protection against inflation and a risk premium.
In setting the fed funds rate, the Federal Reserve can ignore the risk premium because the market assumes there is no chance of default on short-term government securities. That means the fed funds rate should focus on protecting investors against inflation and providing some income.
Inflation, according to the latest data from the Bureau of Labor Statistics, is running at 2.4% a year. Before the financial crisis, the fed funds rate was usually above the rate of inflation, which can be seen in the chart below. In the chart, I subtracted the rate of inflation from the fed funds rate to highlight the periods where the fed funds rate is greater than the rate of inflation. Before 2000, we generally saw this line dip below zero (indicating the fed funds rate had fallen below the rate of inflation) only when the Fed was fighting a recession.
The difference between the fed funds rate and inflation is known as the real interest rate. When the real interest rate is above zero, investors are being compensated for lending money.
So, as I just mentioned, prior to 2000, the real interest rate was above zero except for brief periods of time when the Fed was trying to stimulate growth to end a recession. The exception to that was in the late 1970s, when the Fed allowed the real rate to remain negative for a few years, and inflation reached double digits. That experience led to the theory that negative real interest rates would cause inflation; however, that theory seems to have been proven wrong since the end of the financial crisis.
This creates a problem for investors. If real rates are going to remain negative, then income for savers will remain low, which means they need to consider alternative sources of income, like investing in the stock market. This, in turn, should support higher stock prices, which makes me believe that any calls for the end of the bull market are likely to be premature until the real interest rate turns positive.
I don’t expect that to happen for a few years. In order to have positive real rates, we’d need inflation to fall or interest rates to rise significantly (or some combination of the two). Trends in interest rates and inflation take time to unfold, so we’ll remain in a market environment that favors stocks until those changes take place. In particular, the current environment favors companies that are benefiting from low interest rates.”
Keeping It All in Perspective
I hope this gives you some perspective of the larger game we’re playing here. No matter what happens in the outside world, as investors, it’s always important to ask yourself whether those events fundamentally change the calculus of the larger pieces that are in play.
As Amber points out, the best traders make decisions that are rational on an individual basis. And between two of the most important pieces on the board — interest rates and volatility — the picture is still pretty clear. For interest rates, the Fed has sent clear signals about its intentions. That should go a long way toward putting your mind at ease.
But what about volatility? I mentioned earlier that the VIX had recently touched a 24-year low. Let’s unpack that for a moment…
It’s true that volatility has been low. It’s also true that most in the financial media point to low volatility as a sign of a looming crash. But the reality is, as Amber recently pointed out, low volatility may not be a bad thing.
As she put it: “Many expect the bubble of complacency to burst, leaving traders unprepared for the challenge. But I’m not sure that’s the right way to think about VIX.”
While low volatility does make it a little more challenging for options traders to earn fat premiums, the reality is that Amber and her readers have been able to find good income trades in just about every market environment. That’s a big part of why she has one of the best track records in the business.
Amber’s take is that low volatility just implies that most traders are on the same page. Right now, traders are expecting a slow market over the summer with low volume and little risk.
With the VIX low like it is now, Amber’s not simply planning for the worst and biding her time. Nor does it mean she’s blind to market risks. As a former military intelligence operative, she sees risk everywhere.
My advice: Take a page out of Amber’s playbook and assess the risk of each trade you make and look to minimize risk. Don’t worry about outside noise. That’s been how Amber and her Income Trader readers have been able to generate income week after week, often earning hundreds (or thousands) of dollars on each trade. With that outlook, you’ll never have a chance to become weak and get blindsided. You also won’t miss out on profits, either.