A look at the recent sharp swings in equity indices
Over the last ten days or so we have seen US equity markets whipsaw in 1000 point ranges without obvious cause or explanation. What's more, this has happened on three occasions in quick succession. This type of market move is not unprecedented, but it is relatively rare. We would need to look all the way back to August 2011 to find a period where markets moved as powerfully as this; then we had four consecutive days of extreme volatility. Those moves came against the background of a Euro crisis, as the impending failure of the Greek economy sent the markets into strife.
As I write, we have had three sharp sell-offs in a little over ten days, so the concentration of wild moves is lower than seen in 2011. But against that, this time there is no clear cause or catalyst, for traders to rationalise or benchmark those moves against. Of course, 1000 point swings in the US30 and 3.75% moves in the US 500 index don't (or shouldn’t) just happen randomly or without reason. But we have to do quite a bit of digging to get close to a salient explanation for them.
Cause and Effect
First of all, let's exclude those items that did not contribute to the sell-offs. The initial down leg in US stocks followed the February meeting of the US Federal Reserve, then there was concern about inflation and the pace at which the Fed might tighten US interest rates. But following the January Non-Farm Payrolls, released on the second of February, concerns about the growth in US wages were added to the mix and the Dow plunged by some 1100 points as a result. But something doesn't add up here because if we look at the chart below - that plots average hourly earnings in the US against the monthly change in inflation in the country - we find that both are currently trending lower.
What’s more, as we have noted before, higher Oil prices have a direct influence over US inflation expectations and yet both the Brent and WTI crude prices have been correcting lower of late, so I think we need to look beyond these metrics for our explanation. If fears about inflation were a cause of the instability, we need to find another source or input to blame.
Implications of Global Growth
The source of those concerns could conceivably be the pace of global growth and its implications. Don't forget that since 2009 central banks have effectively bent over backwards to create benign financial conditions adding trillions in liquidity, cutting interest rates in some to below zero and implementing QE plans that saw tens of billions of Dollars, Pounds, Euros and Yen being spent on buying assets each month. With global growth currently looking so robust, central bankers are now considering the normalisation of monetary policy and an end to the use of unconventional tools such as QE. I think this is a much more likely source of concern or anxiety to the markets. For nine years, they have effectively been hooked on a potent cocktail of financial opiates in the form of cheap money and the presence of a perpetual buyer of assets. Now that their supply may be cut off, certain sections of the market have reacted hysterically.
The Return of Volatility
That hysterical reaction showed itself in a particular (and specialist) area of the markets where the funds and strategies that were sellers of volatility. Volatility is a measure of the frequency and rate or rapidity of price changes, in an instrument or group of instruments. It's often measured as a % change and that change is typically expressed via an index. One of the most well known of which is the CBOE VIX index.
The trillions spent buying assets under QE have meant the price of bonds and equities have, for the most part, risen in a measured and predictable fashion for much of the last nine years. In other words, there has been little or no volatility during this period. In this benign environment selling instruments linked to volatility and using the sale proceeds to buy other appreciating assets had become quite a popular thing to do. It had come to be seen (incorrectly as it turned out) as a largely risk-free strategy. But as we have pointed out before, those that are within a bubble are subject to confirmation bias, anchoring, availability bias and a host of other traits, which prevent them from realising what's going on around them. As my grandmother used to say, there are none so blind as those that cannot see.
Heading for the Exit
Far from being in risk-free trade those in this low volatility were, in fact, moving ever closer to a precipice. Crowded trades are often likened to being at a giant party - it's fun while you are there but ends in tragedy if everyone heads for the exit at the same time. That's effectively what has happened over recent days, as volatility picked up, so those that were short volatility sought to cover or rebalance their exposure. That meant buying back volatility and selling the assets, they had bought with their volatility sale proceeds. But in doing so, they drove volatility higher, and stock prices lower. As volatility moved higher, the short volatility crowd had to close more of their volatility shorts and sell more of their equity holdings. Which of course drove share prices lower and volatility higher creating a negative feedback loop. Now add in a lack of liquidity in the market for volatility, to the mix, and you have the perfect storm or stampede for the exit.
Contained for Now
This series of events is played out in the chart below, which plots the US 30 index vs the CBOE VIX index.
The market structure that has been built up since the Global Financial Crisis or GFC has a few buffers such as the limited human interaction or position taking at scale, and as such is very directional, hence the 1000 point moves in the Dow and the near quadrupling of the VIX.
For now, the damage has been contained within the relatively narrow confines of the short volatility strategy. The concern would be if it spilt over into the wider market because if you think about it buying and holding equities for the last eight or nine years, supported by QE, has effectively been a short volatility trade all of its own.
What’s Next for Global Indices?
In the last two sessions, US equities have posted gains, suggesting that things may have calmed down. As tempting as it is to believe that is the case, I would urge continuing caution since the recent burst of volatility came out of the blue and without warning. That said, there are opportunities for traders in these type of markets if they act in a sensible manner. Most importantly don't try and pick tops and bottoms. That's something that is hard enough to do when a market is acting rationally, let alone when it's under duress. What we will see in such circumstances is the development of strong directional trends. Letting those trends develop and then joining them is probably the most sensible way to trade such large swings. But one must use a sensible stop loss and reduce or scale back trade sizes under these conditions. It may also be sensible to trade equity indices within their local market hours and not to carry out of hours or overnight exposure in these instruments while the volatility persists.
As for levels to watch, the volatility began in the US 30 index and the index is in a bear trend in my midterm model. After recent rallies, it is only a weak bear trend and if it breaks or closes above 25300, would move back to bull. The broader-based US 500 index is in a somewhat stronger bear trend, which would be negated at or through 2730. The tech-heavy US 100 index is in the strongest bear trend of the three, and the index won't be back to the bull trend until it's at or above 6720. Note though that the model trends referred to are technical mid-term trends, measured on an end of day basis and therefore distinct from the intraday moves discussed above. That said, any further sharp counter-trend rallies in US equity indices, such as on Friday the 9th and Monday the 10th of February, could redraw this landscape very quickly.
The US CPI and Eurozone GDP data due to be out on Wednesday and a series of central banker speeches on Thursday are all potential fundamental catalysts for further sharp moves in equity indices. I will also be watching the Dollar-Yen rate closely, as the Japanese currency can act as a risk on / risk off barometer; attracting flows when risk appetite fades. Recent Yen strength could be indicative of such risk-averse money starting to move into the Japanese currency.