Kinahan And Laffman: Volatility Demands Discipline, Fed Rethink

Most investors probably won't argue: It's been a crazy start to the year, said JJ Kinahan, Chief Strategist, TD Ameritrade. In a bruising sell-off, the S&P 500 (SPX) has tumbled over 9% since the start of the year and the CBOE Volatility Index (VIX) surged to the 30 level, flashing its historical warning signal.

Kinahan joined Craig Laffman, Director, Fixed Income Trading and Syndicate, TD Ameritrade, to discuss the wild swings gripping markets in recent sessions.

For investors looking to make sense of the market mayhem, Kinahan pointed to a dramatic spike in the correlation between the price of crude oil and the S&P 500. "You are trading crude oil whether you realize it or not," said Kinahan. Normally, the correlation between the two is in the 50-60 range. Since the start of the year, the correlation is over 90, Kinahan said. U.S.-traded West Texas Intermediate crude oil tumbled as low as $28 per barrel this week, its lowest level since 2003.

At first glance, the economic backdrop created by lower crude oil and gasoline prices could be a supportive factor for consumer spending and overall U.S. economic growth. "The odd thing right now is that the general population has not been out spending," said Kinahan. Estimations indicate that out of every $1.00 saved at the pump, consumers are spending 33 cents, while 67 cents is siphoned toward paying down debt or building savings, he says. There is a beneficiary of lower crude oil prices and that’s the auto industry. "Gas is cheap, so people are buying cars and not necessarily electric cars," said Kinahan.

Earnings Aren't Bad

If you are looking for something to hang your hat on, you aren't alone. In the midst of the seeming market chaos, there has been some positive news.

Through Wednesday, 46 stocks out of the S&P 500 have reported Q4 earnings. "Thirty-five out of the 46 have beaten earnings expectations. Of the 14 financial stocks, 11 have beaten earnings. That is pretty amazing," said Kinahan. Wall Street did lower overall earnings expectations heading into this reporting round.

The Safe-Haven Play?

U.S. Treasury bonds are a traditional safe-haven trade in a risk-off environment. Treasury yields, which move inversely to their price, have dropped since the start of 2016. The yield on the benchmark 10-year Treasury note—used to set mortgage rates and other key lending rates— touched an intraday low at 1.93% on Wednesday. That was its lowest since October.

However, the retreat hasn't been laced with panic.

"This has been one of the most orderly markets I have seen in my near two decades of experience," said Laffman. "Foreign entities have taken advantage and are cashing out of large positions," Laffman said. He pointed to China which holds north of 1.3 trillion in U.S. Treasury securities and said: "When you see the Chinese selling very large blocks of Treasuries it takes time to absorb the excess supply."

What About The Fed?

The retreat in Treasury yields could be triggering some consternation over at the Federal Reserve following the central bank's nominal .25 basis point rate hike at the end of 2015. "This is not how the bond market is supposed to react when a monetary policy tightening cycle is intact," Laffman said. The bond market indicates the looming question that needs to be answered is the disbelief as to what the Fed will actually do in 2016, he said.

Expectations for future Fed rate hikes are quickly being downshifted. Heading into 2016 there were forecasts for as much as four quarter-point rate hikes this year. Now, "looking at Fed funds probabilities you have to go out to the July meeting to see a probability north of 50%," said Laffman.

The Treasury market is registering uncertainty about the global growth and macroeconomic storylines, said Laffman.

Within the bond market, the high yield area may be worth monitoring ahead. "Borrowing in the junk bond market in 2014 by oil services companies totaled about 18-20% that year when crude oil was trading about $52 barrel. That -indicates companies need crude oil to be north of $40 per barrel in order to repay those bonds," said Kinahan.

"If crude oil doesn't stabilize the longevity of some of these companies could be tested and we could see a spike in defaults," which could have a snowball impact throughout higher quality bonds, Laffman commented.

Key Drivers For Markets Ahead

1. Watch Central Banks: "There are some big economic releases on the horizon. But, this is a market concerned about the growth prospects of China and the continued slide in crude oil. Focus on central banks. They can be like Zeus with thunderbolts—swift and furious—and the market is likely to follow their direction," Laffman said.

2. Listen In On An Earnings Call: Kinahan points to GE's earnings release on Friday as a place investors can look to for potential global guidance. "They are still one of the biggest global companies. Their earnings are very interesting because they are involved in some many different areas of the world. If you want a quick snapshot of what is going on in the world the GE earnings call can give you a quick picture of what's going on," he concluded.

Last word: Kinahan said the current trading environment likely means investors have to be more disciplined than ever. "Things will settle down at some point. You have to keep your downside sort of protected. Consider keeping your position sizes smaller than normal when volatility increases and wide out your stops and sell/buy prices as well," Kinahan suggested.

Want more on the markets? Follow @TDAJJKinahan on Periscope for his next Market Update, Friday January 22 at market close (4pmest). Not on Periscope? Follow JJ on Twitter, and a viewable link will be posted there once he’s live.

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