Why Stocks Crashed On Friday

Stocks Were Overbought

The stock market had a wicked decline on Friday as the Dow was down 2.54% and the S&P 500 was down 2.12%. The VIX was up 28.51% to 17.31. This was the worst week in 2 years. The S&P 500 was down the most since September 2016. There were a few reasons for this decline. The first was that the market had run too much. The record streak without a 3% sell off was snapped at 311 days. This was way more than the record in the mid 1990s which lasted 241 days. Many other indicators where flashing that stocks had run too far too fast. I called for a correction like this to occur 3 weeks ago because I thought stocks were running up too fast. The good news is that this decline makes stocks less frothy. I’m now neutral on the near term instead of negative.

AAPL and Alphabet Had Weak Earnings

The other reason for the decline was the weak earnings results from Apple and Alphabet. I will review the Alphabet results in another article; the stock was down 4.78% on Friday. The chart below shows the worst performing stocks in the S&P 500 this week. As for the worst performing Dow stocks this week, Chevron was down 9.6%, DowDupont was down 7.9%, Intel was down 7.8%, United Health was down 6.7%, and Apple was down 6.5%. The tech sector was down 2.96% on Friday and the energy sector was down 4.13%. Oil was barely down as it closed off 35 cents at $65.06. Gold was down 0.94%. Gold doesn’t have a rhyme or reason for its action. Sometimes it works as a safe haven and other times it doesn’t.

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The 10 Year Bond Yield Soared

As with most aspects of the market, there isn’t consensus about the 3rd cause of the sell off on Friday. Some say the rising rates played a role. As you can see from the chart below, the sell off in the 10 year bond has recently coincided with the sell off in stocks. We’ve discussed the yield at which the 10 year bond would start to hurt stocks. Previously, that marker was 5%, but according to recent analysis we concluded it was 3.5%. This chart makes it look like 2.7% was the magic number. That’s a big problem if that’s true because inflation is only getting started. The 10 year bond yield was up 5 basis points to 2.84% on Friday. I could see it hitting 3% soon if inflation continues its upward momentum. On the bright side, the yield curve steepened. The difference between the 10 year yield and the 2 year yield is about 70 basis points. That’s a swing of 20 basis points in the past few days. A swing in the opposite direction would have put the bond market very close to an inversion. This type of countertrend rally is why I said the inversion will likely occur between the second half of 2018 and the first half of 2019.

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Further supporting the notion that increasing 10 year bond yields will cause a stock market correction is the chart below. As you can see, whenever the trendline is hit, there’s some sort of volatility event. The greater the government debt, the greater the sensitivity to increasing rates. The housing market will also take a hit if rates continue higher. Rising rates and inflation will cause a recession. I’m sticking to the notion that there is more room to run before a recession, but I’m open to being wrong given the sharp action on Friday. The recent Fed futures added another rate hike from the end of 2018 to 2020, making for two hikes in that period. The hawkish policy decisions in the next 2 years will cause a recession. Like I said earlier, I don’t think now is the time to worry about a recession and a bear market. That being said, it’s possible stocks are overly sensitive to potential economic weakness because of their extremely high valuations.

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Some Say Higher Rates Didn’t Cause Selloff

My belief that there is still room for rates to go higher before a bear market is supported by the notion that this wasn’t a rate driven sell off. As you can see from the chart below, the 10 year treasury and stock market started the day inversely correlated, but then at the end of the day when there was panic selling, the stock market fell and yields fell.

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Furthermore, the rate sensitive sectors did the best while the cyclical sectors sold off. As you can see from the chart below, the utilities were only down 0.80%. The financials are thought to benefit from higher rates, but they were down 2.18%. This current market is the perfect world for the financials because rates are rising and the yield curve is steepening.

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Short Volatility Unwind

If the rising yields didn’t cause the sell off in stocks then what did? Some say the decline came from the short volatility trades unwinding. With the extremely low VIX, it became advantageous to short volatility in the past 2 years. As you can see from the chart below, the fund flows to short volatility exchange traded products have increased recently. The XIV was up 102.8% from August 17th to January 11th. Since then, it’s down 20.31%; it was down 10.67% on Friday. The SXVY was up 102.56% from August 17th to January 11. Since then, it’s down 23.59%; it was down 13.21% on Friday. Saying the stock market fell because the short volatility trade unwound is just like saying stocks were overbought except this explains the speed at which stocks sold off.

Conclusion

If you’re a short term trader figuring out where to buy bonds, I’d say the 10 year bond yield is likely over sold. The stock market still isn’t a bargain as it’s up 3.31% year to date. The medium term outlook for stocks is still great because of strong earnings and a decent economy. This was a sell off to get rid of the froth in the market. As I said previously, I think there will be a 10%-15% correction this year, but stocks will rebound mostly.