By Ross Silver & Greg Harrison

Volatility, hello there my friend! We wanted to publish our newsletter on the 2nd but the DJIA dropped nearly 700 points on the 2nd and as such we pulled back as we wanted to gain an understanding of what transpired and what seems to be on the horizon. So, “Fortune Teller” Ross, please be so kind as to enlighten us on what happened and what seems to be on the horizon. I am no “Fortune Teller”, but I will share with you what I think happened and what is in store. Let’s start with what happened. Two weeks ago I received my weekly Baron’s newspaper or magazine and the first article is Randall Forsyth’s article which mentioned that investor confidence is the highest it has been since 1980 in one confidence tracker and the highest it’s been in another confidence tracker. At that moment, I laughed and said to myself, it may finally be time to buy some VIX calls and buy puts on the S&P. Sure enough, Friday hits and I was lucky enough to have purchased some ticker: UVXY, which is a volatility ETF, and that thing went from $10 and change straight to $14 on Friday the 3rd. From $14 it shot to $30 and the VIX hit an all-time high of $50 on Tuesday, what fortuitous timing and RADICAL MAN! For those of you that follow our tweets, @SylvaCap, you hopefully were making money right alongside me. Let’s then move to last week where on Friday at around 1:40pm est, I sent my mother an email stating, “this is the bottom” and sure enough, the DJIA which was down about 400 points, reversed course and closed green. How on Earth could I possibly know that and what happened? The answer is a combination of panic and fear mixed in with algorithmic trading platforms and we have ourselves a fully weaponized market that can destroy years of investing gains in an hour. Welcome to 2018 ladies and gentlemen, this new reality is scary and we only got a taste.

So what is coming? Well, I see things calming down a bit as we head into the spring. I think volatility subsides and we will see the major averages erase the losses of the past week and I think a fresh set of all-time highs is on the horizon. With that stated, I also see a free fall that I think hits during the summer after the Fed has raised rates for the second time. We are very much focused the yield curve in relation to overall financial health. Last November, we wrote about yield curve at length which you can read here. In that article we noted that historically, the market peaks approximately seven months prior to a recession, and roughly three months after the end of a yield curve inversion.

Interest rates for long-term bonds have been rising over the past two weeks while short term yields have remained flat. It’s important to note that the curve isn’t inverted yet, however the Federal Reserve (“Fed”) indicated that they will continue to tighten fiscal policy and raise short-term interest rates. The market is expecting about three rate hikes this year, which would add another 0.75 percentage point to the two-year yield. If the 10-year holds still…it’s the dreaded inversion. Dallas Fed President Robert Kaplan still sees some room to maneuver, he said, but added, “I wouldn’t be sanguine about an inverted yield curve.” They’ve also indicated that they intend to continue issuing short-term debt instruments to plug budgetary shortfalls. Both of these actions should continue to compress the yield curve.

The other metric we’re focused on is inflation. We’re expecting inflation to increase this year, and we believe it started to creep in last year. In 2017, the labor market tightened. Unemployment dropping is unquestionably a good thing, however more jobs with fewer applicants gives employees leverage to demand higher salaries – an inflationary cost which is ultimately passed on to consumers. In addition, a weaker dollar in 2017 made imports more expensive, and according to PIMCO (one of the world’s largest asset managers), the price of cell phone plans were reset in 2017, which artificially capped inflation (go figure). Additionally, President Trump’s business-friendly agenda should spur economic growth, and with it more inflationary pressure.

Currently the inflation break even curve is flat, which means market believes inflation levels won’t get back to the Fed’s target of roughly 2.25%. It appears as if the market is pricing in two rate increases this year, even though the Fed has signaled there could be three. PIMCO believes the Fed is actually engineering a slight overshoot of its target inflation rate, and that we’ll hit the target sooner than the market is anticipating. If that happens, then the Fed will likely raise interest rates three times in 2018, which could cause the market to correct. The reason is because rising interest rates are intended to “cool” the economy, which means corporate growth will slow. As a general rule, investors don’t like when that happens.

You never know what you don’t know until it happens. For several months now we’ve been expressing concern about a potential threat coming from the geopolitical arena – but it could easily be something else. The fact is it doesn’t matter what “it” is. As any purveyor of Black Swan Theory will tell you, the probability of any single black swan event occurring is remote, however the probability of a black swan event itself, is not. That is why the intelligent investor always takes risk into account. Always. The market seemed to have forgotten that piece of time-tested wisdom and it will forget again, but the next go around will be a true test and as I stated earlier, this past week was only a taste.

The companies we like for the long term are listed in the Investment Ideas section of our website, and our Sylva Portfolio represents our best trading ideas and we are up YTD. We will continue to scour the market for companies we think will thrive in any economic environment. Good companies are built for the long haul, and we think we’ve identified some excellent investment candidates.

Be smart.

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