The return of volatility over the past four weeks has been quite a reality check for the market and its participants. However, it has not shaken our resolve and our bullish outlook for 2018. Economic data and forecasts remain robust, but improving economic conditions are a double-edged sword for the market.
Historically stocks tend to struggle in rising rate environments, but these levels are still well below historical averages for the 10- Year Treasury yield and below the lower end for the benchmark yield of around 4% prior to 2008. The uptick in growth, inflation, wages and corporate profits stoked fears of an accelerated run up in interest rates, which spooked traders and investors and heralded in a return of volatility that began at the end of January.
This influx of real volatility — larger daily and intraday market index price swings — caused a run on the latest Wall Street invention: low volatility derivatives, especially inverse volatility Exchange-Traded Products (ETPs). The long-awaited 10.2% correction that appears to have found support at the February 8 close — at least for now — has brought valuations, stock prices and the overbought conditions back in line to less overextended levels.
It’s been two full years since the last 10% correction, so make no mistake; this was a warning shot that market volatility has returned and the days of super easy gains being long and strong stocks and the broad market and short volatility are likely over. This makes the historical time-tested seasonal trading trends and pattern for frequency and magnitude detailed in the Stock Trader’s Almanac for 51 years, even more imperative to consider.
The fact that this correction happened in classic fashion in February, the weak link in the Best Six Months, where big January gains often correct or consolidate, lends support to the efficacy of and return of market seasonality. This looks like a textbook setup for a midterm-election year Worst Six Months market soft patch and perhaps further correction during the May-October period.
March historically remains strong in midterm years, but April, May and June have been weaker in midterm years, so we suspect the rally to resume higher toward the January highs in March. Volatility is likely to continue, but we don’t expect another meaningful pullback until the end of the Best Six Months. Midterm election campaign machinations and political rhetoric are likely to heat up already heightened tensions in Washington, fanning any market jitters from the new Fed, higher rates and market gyrations.
Bullish sentiment has come down considerably and technically the market is going through a constructive consolidation. Finally, while midterm March is historically strong, like Julius Caesar: beware The Ides of March as well as the week after March quarterly options expiration and the end of Q1. The market tends to come into March strong, but then after mid-month is prone to weakness and big end-of-Q1 hits.