foxex: Pulling Back

Chart Advisor | Focus on the Price

Friday, January 24, 2020

1. Prices fall as nervous investors take profits

2. Pharma stocks reverse course

3. Fund managers move towards safety

Market Moves

Stocks opened slightly higher on the day with Apple (AAPL) shares, among others, hitting new highs. However as the minutes progressed, sellers took over and the broad market indexes trended lower all day long. The Nasdaq 100 (NDX) and the S&P 500 (SPX) closed nearly one percent lower while the Dow Jones Industrial Average (DJX) fell just over one-half percent.

When markets get spooked, fund managers and professional investors seek to protect their positions. Typically they buy put options and sell futures contracts as a means of hedging against falling prices, and when they do this it moves the needle on the Volatility Index (VIX). VIX prices are negatively correlated with broad market indexes so when stock prices fall it is no surprise to see this index rise. What might lift eyebrows for investors, however, is noticing different movements between VIX prices and the prices of VIX futures.

The chart below compares the jump in the VIX with the movement of the VIX futures contract expiring next month, and the contract that expires in two months. The one-month contract (purple line) jumped right on cue with the VIX, however the two month contract (yellow line) lagged behind the other two. This is an interesting development that suggests, at least for now, that investors expect this price pullback in stocks to be short lived.

Pharma Stocks Reverse Course

With stocks pulling back in price rather notably, naturally financial media experts look for a reason to explain the move. The most notable event in the news right now is the China-based Coronavirus outbreak. It wouldn't be too hard to establish a connection there since industry groups such as airlines and assets such as the inverse China Index funds showed significant movement. But this seems likely an incomplete analysis. For one thing, the VIX futures markets seem to indicate the fear in the market right now is based in a much shorter time frame than that of a disease epidemic.

Consider how the chart below details the movement of one industry group heavily hit today: pharmaceutical companies. Some investors might intuitively expect that these companies would likely benefit from selling a cure for the outbreak, and then wonder why these stocks should be falling. The answer is that since none of them have such a drug under development, the significant cost of shifting resource around would hit these companies' bottom line quite hard. Further, companies like this can't really charge a premium when any drug that could help would need to be delivered at low cost to help with a humanitarian crisis. The market appears to fear these companies may soon be pressed into charitable service.

The companies most heavily hit appear to be among the holdings of State Street's S&P Pharmaceuticals index ETF (XPH). These include Amgen (AMGN), Abbvie (ABBV), Pfizer (PFE), and Merck (MRK). Though Eli Lilly (LLY) and Gilead Sciences (GILD) also dropped today, the moves were not nearly as significant, suggesting that the market thinks there is less risk to these companies for some reason.

That the selling is not uniform among these companies suggests that there is a more complete explanation of what is happening right now: profit taking. Fund managers could see signs of market risk for themselves and knew they had to reduce risk in whatever way they could. So it shouldn't come as any surprise that when they found an excuse to lighten up on a particularly risky industry group, they decided to do so.

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Fund Managers Move Towards Safety

Though the spark for this movement may have been the epidemic headlines, the chart below shows that investors were likely planning for this eventuality for a little while now—perhaps since the beginning of the year. The price of gold index ETFs have moved higher (GLD) as have bonds index ETFS (TLT). However the favorite asset among hedge instruments right now is stocks in the utility sector as tracked by State Street's Utility index ETF (XLU). The movement on XLU hints that fund managers have felt this need for a while now.

The Bottom Line

Stocks moved lower right from the open as fears of a Coronavirus outbreak drove headlines. The VIX futures show that this may not be a long lasting pullback. Pharmaceutical companies fell while Utility stocks rose, suggesting fund managers are rotating their money to safety.