Last year was unusual in many ways for financial markets. When expectations for how events normally unfold become challenged by data way outside its normal range, it is easy to imagine the world has gone mad. A science-fiction genre exists where the protagonists have jumped to (or awoken in) an alternative world. Think "The Man in the High Castle," the "Star Trek" episode "Mirror, Mirror," and "It Can't Happen Here."
To this group, you can add a new title: "Outlier 2017." I can imagine the sonorous baritone voiceover during the opening scene: "It was a year filled with aberrations." To wit:
- Above-average U.S. market returns;
- Record corporate profits;
- Even higher returns overseas, especially for U.S. investors when priced in dollars;
- Record-low market volatility;
- Record-high political volatility;
- Fed funds rates near record lows;
- Market interest rates near record lows;
- Below-normal inflation; and Low bond yields.
But those unusual data points are ephemeral, as statistical outliers always revert to historical means -- eventually. And so that is what we are living through this year. Indeed, if 2017 was a year of eccentricity, then 2018 represents a return to normalcy.
What has changed? Combine above-average returns, the passage of time, and a very specific technical event, and you create the right environment for reversion. The U.S. equity markets have risen for nine consecutive years, and during seven of those nine years, it rose by double-digit amounts. It's easy to see markets getting a little ahead of themselves, and needing to digest those gains. Those who look at the longer market cycle after this fantastic run wouldn't call a quarter or three of sideways action unexpected.
Why did volatility suddenly return? Consider that long run of gains by the broad indexes. Active traders and hedge funds found a profitable trade in making highly leveraged bets against volatility. Of the dozen or so exchange-traded funds and exchange-traded notes designed to make this bet, much of the capital was concentrated in just a few of them. The precise factor that precipitated the blow-up of these products is unknown.
My best guess is that someone somewhere back in February decided enough was enough -- it was time to take their chips off the table. For some historical perspective, let's look back to December 2006, when the VIX, which is sometimes referred to as the market's fear index, hit a cyclical low of 9.39, just as the housing market began to stumble and stock markets were beginning their final run-up ahead of the Great Recession and a subsequent 57 percent crash. For anyone looking for a technical signal that the moment had come to unwind a levered VIX trade, that time was as good a time as any.