Today you’ll hear the term ‘triple witching’ a lot in the media — it refers to four Fridays a year when stock index futures, stock index options, and stock options all expire on the same day. The expiration can lead to unusual volatility in markets as traders scramble to offset positions. This could make things quite bumpy, but I think there may be a more important triple witch – one that has provided the catalyst for a deep correction in U.S. markets.
My triple witch consists of three events that have transpired recently to rattle financial markets.
There continues to be deterioration in global markets — in particular, the emerging markets. Recently we’ve watched as the credit markets in China are freezing up. One only has to look at CHIBOR, which is the Chinese interbank lending rate, to note that lending markets may be seizing up. When bank lending is restrained, bad things can happen to asset prices. It seems that China will need to offer some monetary assistance soon to stop the bleeding and allow liquidity conditions to stabilize. The complication is that some think the government is intentionally restraining lending to try and prick a runaway real estate bubble.
The recent Federal Reserve meeting made it very clear that the Fed plans on weaning the market off of some of the juice that has been pumping through the global financial system. Good perspective tells us that rates are still low, and it seems likely that tightening of the federal funds rate won’t occur for some time. But markets move on the rate of change, and the important signal coming out of the meeting is that the fed balance sheet is about to start shrinking. The feds open ended commitment to buying $85 billion a month has arguably put a prop under markets for many months, and the dominating theme has been not to fight the fed while they were providing the liquid. The direct change in stance will likely cause investors to reconsider risk and recalibrate expectations. This may be healthy for markets long term, but it will not likely be an easy adjustment in the shorter term.
Not only is the Fed preparing the markets for less accommodation in our future, but it’s also apparent that Chairman Ben Bernanke will not be back for another term. Some would argue that the Federal Reserve won’t skip a beat when Bernanke leaves, and that the consensus pick for a new chairman is the ultra-dovish Janet Yellen. I would argue that it is far too early to pencil in Yellen yet, and that the loss of Bernanke will likely cause some indigestion in markets. Ben Bernanke had built up a market-friendly reputation as a leader who was concerned with fighting deflation and was always willing to supply markets with liquidity at the first sign that data was ebbing or markets were rioting. Bernanke was also quick to be creative and implement new programs.
For many years the market has lived by the slogan, “In Ben We Trust.” Markets now know the days of implicitly trusting the U.S. central bank are coming to an end. Change at the central bank is part of life, and a new face may be a good thing long term. But in the shorter term, this brings a new level of uncertainty and anxiety to markets.
We may get a reflexive bounce over the coming day or two, but we advocate staying defensively positioned for the time being. The conditions for correction have collided with the necessary catalysts and this correction is already deeper than what we have witnessed earlier in the year. We still view this as an overdue corrective process and not a bear market, and ultimately we’ll be looking for a time to turn the guns and start buying more equity at lower levels.