Well, that escalated quickly. The biggest one-day drop in the Dow Jones Industrial Average, in terms of points not per cent, was all over the news this morning. The drop wiped out the impressive gains for 2018 so far. And the futures are down even more, suggesting the rout will continue for a third day.
In December Tim Price issued a warning to investors that stockmarkets looked dangerously vulnerable to a reversal. I would urge you to read it as soon as possible. Click here to do so.
As I write this, futures in the Japanese stockmarket are down a whopping 8%, comparable to the Fukushima disaster and the 2008 crash. Japanese stocks are down more than 9% in two days.
The funny thing is, there is no obvious cause for all this. In fact, the crash fits any one of a dozen narratives. We’ll look into a few below.
The problem is, without a clear narrative to go by, how do you figure out what’s going to happen next? If there’s no cause to identify, how do you predict when the crash will end?
Let’s examine exactly what happened to discover who might be right about why the market is crashing…
The crash began on Friday when the US jobs report posted the biggest wage gains for workers since 2009. Now you might think this is a good thing. But we’re returning to the twilight zone of finance and economics. The world where “bad news is good and good news is bad”.
That’s because good news forces the central bankers to intervene with tighter monetary policy. And in a recovery floating on loose monetary policy, Wile E Coyote just realised he’s running on hot air.
In other words, the higher wages in the US raise the prospect of inflation. And that means interest rate hikes are more likely, more soon than anticipated. But financial markets know they can’t afford higher rates. They had been betting that rates won’t go up.
Of course, central bank interest rates are just part of the story. You also have government bond interest rates – set by the free market and quantitative easing (QE) policies. In the government bond market, yields surged to levels not seen since 2014. This spike in rates immediately affects debt markets around the world, making debt more expensive.
This spike in yields is what most people are blaming for the stockmarket crash. But Bloomberg, the Financial Times and even ABC News in Australia sent out their experts in force to reassure everyone. Rising yields are good news, they said. Hold on to your stocks and watch our next segment on breast cancer screening.
One Bloomberg market commentator pointed out that the jump in yields is still tiny. Which only makes it all the more remarkable that this can trigger such a tumble in stocks. Not to mention how much worse things could get if interest rates go back up to more normal levels.
Incidentally, our own Charlie Morris at The Fleet Street Letter warned his subscribers about all this. He released his warnings on Wednesday too, two days before everything hit the fan.
His report is titled ”How to survive and profit as the bond market reverses”. The bond market reversed on Friday, triggering the rout. The bad news is, the recent action is just the beginning. Given that, I’ve asked his team to make the report available to you here.
US stocks turned down even faster when the memo I’ve been writing about was finally released. As expected, it revealed abuse of spying powers during the 2016 US election by Democrats, backed by anti-Trumpers in the intelligence community and the Department of Justice.
A dossier about Donald Trump, paid for by acolytes of the Hillary Clinton campaign, and compiled by an anti-Trumper working for a Russian firm, was used to secure a warrant to spy on a member of his campaign team. Put this together with the other information released these past few weeks and you have a mounting case of election manipulation and abuse of powers. No wonder so many people have resigned and been reassigned.
The market certainly seemed to agree there’s something to the story. The question is whether Trump is just as guilty as his Democrat opponents. Ideally, everyone would be arrested, leaving the American people with nobody to meddle in their affairs for a few months while the political system resets.
The Dow eventually settled down a haunting 666 points on Friday.
But the action continued on Monday when markets around the world reacted to the US tumble. And then the Dow index took its biggest hit ever in terms of points on Monday too. It recovered some of the losses towards the end of the day though.
But why? Why did stocks fall again on Monday? There was no major event. Well, not one you’d expect to impact the stockmarket.
The new Federal Reserve chair was sworn in. You’ll be hearing a lot about Jerome Powell in coming years.
But not much else happened.
Momentum and reversion to the mean
The most convincing argument for the sudden drop in stocks is simple. They went up too fast.
It sounds silly. And it probably is. But it’s how market players think about things. And they do it in a very sophisticated way.
For example, stocks usually bounce around on the way up or down. You always have a few down days, even in a bull market. The longer the continuous run of daily gains, the more likely you are to have a down day.
There are all sorts of indicators for this. The Relative Strength Index is popular. It tells you whether stocks are overbought or oversold over a chosen period of time.
Just before the crash these last two days, stock RSIs approached record highs. Stocks had gone up too far too fast, without a drop in between. The RSI is mean reverting, so a drop had to happen.
It’s much the same in the VIX world. The VIX is a measure of volatility. It’s been trending down suspiciously in a world where central bankers buy everything. But thanks to the last few days trading, the VIX went bananas. From below 10 to above 40 in just weeks. It’s only been higher five times in more than ten years!
The really jarring aspect is how suddenly it rose. An exchange-traded fund which bets on the VIX going lower lost 87% of its value in a day. It was popular with institutional and private investors alike.
Again, it had to happen. Markets are not naturally as stable as they had become these last few years. The stability was just a pressure cooker, waiting to explode.
On the wrong side of the trade
But the RSI and VIX’s reversion to the mean don’t answer why the stockmarket tumbled. Not really. They just explain the nature of the tumble – mean reversion.
It’s likely that investors, especially large traders, took a look at these indicators and placed stop losses close to their positions. They knew a correction was coming, so they wanted to ensure they realise the gains by selling out at the beginning of any drop in the market. These stop losses are sell orders that get triggered as the price falls. Of course, they exacerbate a crash by adding to the selling wave.
Adding to this are automated quantitative trading techniques. They react to market events, usually exacerbating them. So, if the market turns down dramatically after months of rising constantly, these programs go from being long stocks to being short. The move amounts to selling vast amounts of assets, making the tumbling stockmarket fall even more.
The good news is that the tumble was nothing like a sudden crash. Everyone is comparing it to 1987, but the charts look totally different. Yesterday’s crash proceeded steadily, not in a single short plummet.
Then again, that might mean it’s not just panic selling that can be forgotten quickly. This might be a selloff with a reason. The rising bond yields, for example. People might be pricing in a less prosperous future.
What you need to get used to here is a new world. What’s good for the economy and what’s good for stockmarkets is no longer the same thing. Because each improvement in the economy signals higher interest rates at the central banks and in markets. And that’s bad news for the stockmarket.
If you haven’t already, I suggest you familiarise yourself with Tim Price’s stockmarket warning. It contains his plan to keep your wealth protected and growing, whatever transpires. Click here to read it.
Until next time,
Nick Hubble
Capital & Conflict
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Category: Economics