Big Boxes in the Penalty Box + Socially Unacceptable Volatility

I apologize in advance for trying to thread together some disparate market themes today.  I’m taking a couple of days off and there are simply too many topics that warrant discussion today.  So here goes…

Veteran traders loath the phrase “worst day since 1987”.  Anyone who experienced the ’87 crash will never forget the abject fear and carnage of Black Monday, and the even worse debacle of the following morning that prompted the hasty creation of the Fed’s so-called “plunge protection team.”  I was a newly minted graduate of the famed Salomon Brothers training program[i], and it was a true baptism under fire.[ii]  I had a slight twinge of post-traumatic shock when I learned that yesterday’s 11% drop in Wal-Mart (WMT) was its worst since 1987.

That was bad, but today’s 24% drop in Target (TGT) is even worse – its own worst drop since 1987.  Like WMT, TGT is seeing margin pressures that reflect their inability to fully pass along rising input prices to their customers and an inventory imbalance.  WMT is currently down over 5%, and the dual misses in TGT and WMT are pressuring other big-box retailers of consumer staples.  Costco (COST) and BJ’s Wholesale (BJ), are currently down about 11% and 15% respectively.  Amazon (AMZN), which you should remember IS A RETAILER, is down 5% after conveniently acting like a tech stock that ignored WMT’s miss to rise 4% yesterday. 

Here are my takeaways:

1. The consumer is still spending, but inflation is making them much more cautious.  Inflation and supply chain worries are putting a significant damper on middle and working class buyer behavior. 
2. Is the supply chain crisis on the cusp of becoming an inventory glut?  We noted yesterday that WMT had excess inventory but that it was too soon to know if that would be a temporary phenomenon that resulted from a timing mismatch that could resolve itself naturally over the coming weeks.  Now that TGT sees similar issues, it raises the concern that these giant retailers might need to cut back their purchases in order to clear their backlogs, thus creating backlogs at manufacturers.  That would be the genesis of an inventory cycle and add to concerns about a potential recession. 
3. My father, who spent his career as an industry analyst covering the retail sector, always warned me that it was difficult if not impossible for the broader market to launch or sustain a rally if the retail sector failed to keep pace.  With the SPDR S&P Retail ETF (XRT) about 40% off its November highs (note that it failed to confirm January’s high in SPX), it is hard to imagine that the conditions are in place for a major market bottom until this sector resolves its woes.

On a somewhat different note, I was asked yesterday why some historical volatility measures rose even on such a strongly positive day.  It is important to remember that historical volatility doesn’t care if moves are up or down, just the absolute value of the moves of the product in question.  A day that is up 2% counts just the same as a day that is down 2%.  Implied volatility is determined by traders’ demand for options.  Traders tend to pay relatively more for options on down days than they do on up days, which is why we tend to see VIX – an implied volatility-based index – move inversely with the broad market.   This article more fully explains the differences between historical and implied volatility.

Finally, we get into what I like to call “Socially Acceptable Volatility.”[iii]  Yesterday is what we would consider a bout of socially acceptable volatility.  No one seemed to mind when major US indices rose 2% or more.  That’s what they’re supposed to do, right?  But there is a feeling that something is wrong when we decline by a similar amount.  That’s fair – most investors are long, and equity markets usually go up over time.  I’ll leave you with a chart that highlights the distinction:

S&P 500 Index (SPX), 3-Day Graph, 1-Minute Bars, May 16-18^th, 2022

Source: Interactive Brokers

[i] The year after Michael Lewis’ training class

[ii] Attention reporters – this year will be the 35^th anniversary of the crash.  I would be glad to discuss my recollections, particularly surrounding the following day – which was actually worse

[iii] A term coined by my friend Steve Sears that I liberally appropriate and literally footnote