Market Catharsis and Time to Buy

Market Catharsis and Time to Buy

It has been a very volatile and difficult week for investors.

To quickly recap, Monday experienced a “flash crash” event, as the Dow fell by about 900 points in 10 minutes, sending the Dow down by 1600 points at the nadir and the VIX more than doubled.

Extreme intraday volatility continued all week long as the market moved sharply lower.

I believe the primary explanation for the dramatic moves in the market have been an implosion of “short volatility” products. I have seen estimates that volatility linked products that were at the heart of the selloff were estimated to have between $1.5-3 trillion in market exposure. These products typically use futures, which have inherent leverage and when the “can’t lose” trade that had worked so well for the last 18 months was forced to unwind as volatility began to spike, it created a cascading effect that forced equity market selling to cover positions.

Numerous volatility-oriented funds and products failed this week, the most widely cited was the XIV ETN which has collapsed by more than 95% from recent highs.

I looked back to the abrupt selloff in August 2015 for guidance on how the current episode might play out.

Alternatively, this may have been an abrupt deleveraging/derisking, “tail wagging the dog” type of an event that could pass quickly. The economic backdrop is so much stronger today than in 2015, that I believe the market will very likely continue its march higher in 2018 and we may be able to avoid a prolonged consolidation period in the market.

The graphic below from Goldman Sachs, essentially confirms the thought process I laid out above. On average, bull market corrections drop 13% and bottom out after four weeks. This correction has been particularly sharp, 12%(intraday) in just two weeks, and back to the 200-day moving average, i.e. the selloff has largely run its course.

One piece of supporting evidence for the idea that the current dislocation could pass quickly is in the chart below. Early in the week, equity volatility experienced a 6 sigma (standard deviations) daily move, which by definition is extremely unusual. Interestingly, other areas of the financial markets such as bonds, currencies and oil didn’t experience unusual or heightened volatility.

We did see some increase in volatility measures in some of these other markets by the end of the week as the correction intensified, but this week’s events were largely confined to the equity market and the “low vol” strategies highlighted above, i.e. no contagion.

This week was a cathartic event that forced leveraged players to unwind positions and exacerbated market moves.

The forced selling described above had reverberations into other areas, such as the “risk parity” trade. Risk parity is an investment concept that typically allocates positions based on risk (volatility). For example, a fund might be “equal weight” stocks, bonds, currencies and commodities based on the amount of risk each brings to the portfolio. Risk parity funds would almost always employ leverage to meet these goals, i.e. bonds and currencies tend to be much less volatile than stocks and a fund would use leverage to equal out these positions. With equity volatility spiking, it would make sense that equity exposure would be pared back to maintain a balanced risk exposure. This is another reason why every intraday rally this week was sold.

I’m not trying to get into arcane market minutiae, but I believe this week’s events were driven by market dislocations and the associated fallout from the unwinding and repositioning of levered trades in the market.

This is opposed to the thought that is being widely cited in the financial media that higher interest rates and inflation fears caused this selloff. I think the inflation/yield angle had some merits early in the selloff, but selling this week was indiscriminate and across the board, indicating to me other factors were at work.

Bottom Line

Several weeks ago, I believed a market consolidation was likely. I believed it would follow the path of other pullbacks since the election, modest in magnitude and time would do most of the “work”.  

This has been one of the most vicious corrections in recent memory, allowing no room for timing error. With that said, I believe this is a violent bull market correction, not the start of a bear market.

The risk/reward profile of the market has now turned decidedly positive. The only exception would be if we are headed for a full-blown bear market or 1987 type crash, which seems highly unlikely. Unlikely because we would need additional contagion effects in the financial markets that we are just not seeing at this time, or an imminent recession, which is also not in the cards.

John Derrick

John is founder of The Derrick Letter, LLC and my passion is the U.S. equity market and my style of investing has bits of a classic growth strategy combined with momentum ... Click for full bio

Most Read IRIS Articles of the Week: Feb 19-23

Most Read IRIS Articles of the Week: Feb 19-23

Here’s a look at the Top 11 Most Viewed Articles of the Week on, Feb 19-23, 2018

Click the headline to read the full article.  Enjoy!

1. Don’t Get Pinged by the Social Security Earnings Limit

I’d like to introduce you to Peggy. Born in 1956, Peggy will be 62 in 2018. She has worked in retail her whole life, the past twenty-five years spent in management. Peggy divorced from her husband 14 years ago, is still single and has no children. — Dana Anspach

2. We're Back to “Bad News is Good News” and “Good News is Great News”

This week the markets shrugged off last week’s fears and went back to the slow and steady melt up, despite economic news that looked likely to once again rock the boat. — Lenore Elle Hawkins

3. Q1 2018 Factor Views

Themes established in 2017 across a wide range of markets and factors continued to resonate through the fourth quarter. Economic growth was strong and supportive of equity markets across the globe, a range of volatility measures reached all-time lows, and business and consumer sentiment remained elevated. — Yazann Romahi and Garrett Norman

4. A Beneficial Basket of Commodities

Advisors and investors that feel they are hearing more and more about commodities and the corresponding exchange traded products in recent months are right. That is a natural result of dollar weakness and yes, the greenback is floundering again in 2018. — Tom Lydon

5. 3 Trends Shaping the Future of Asset Management

As the industry works to cope with new regulation, wades through an outpouring of new products, learns to satisfy investors’ shifting priorities and manages the active-passive debate, the viability of business units will be questioned, and at times radical measures will be taken. Peter Hopkins

6. 5 Ways Advisors Leave Money on the Table, and What to Do About It

My hope is that this article points out some opportunities for you to make more money and serve your clients at a higher level and that you decide to do something about it. — Bill Bachrach

7. The Market Has Gone Wild! Is It Time to Change Your Investment Strategy?

Whether the market is flying high or taunting your emotions with new lows and some bumpy volatility, here are four things every investor should keep in mind ... — Lauren Klein

8. How to Deepen Client Relations and Capture New Business Using Engaging Content

Why financial advisors NEED to understand much more clearly the power of good digital market. With tools like AdvisorStream, it’s easier than ever to get the content you need to drive leads and referrals today! — Kirk Lowe and Matt Halloran

9. Three Ways The Most Successful Gain Big Attention

How do some firms and ideas go from nowhere to everywhere in a few short months? All of a sudden a restaurant becomes popular, a gas station gains a cult following, or a Broadway show becomes too popular to get a ticket for years. — Maribeth Kuzmeski

10. Who Are the Hottest FinTech Firms and Influencers Around the World?

"Worldwide, $27.4 billion poured into fintech startups in 2017, Accenture reports, up 18% from 2016. With so much in play, it’s not surprising that 22 companies are new on this, the third edition of our list."  — Chris Skinner

11. The New Stock Market Normal Is Not What You Think!

Many sensational headlines have been written the past few weeks about market declines, but two things have increased for sure: the viewership and the ad revenues of financial media organizations — Preston McSwain​​​​​​​

Douglas Heikkinen
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IRIS Co-Founder and Producer of Perspective—a personal look at the industry, and notables who share what they’ve learned, regretted, won, lost and what continues ... Click for full bio