After the prolonged period of calmly up-trending stock markets (see chart above) the market correction that occurred over the last 10 days was perhaps overdue and did not come entirely unexpected as regular readers will know. As I wrote in my stock market assessment email on Tuesday, many (us included) had anticipated and warned this might happen, but nobody to my knowledge had been able to predict when exactly it would happen, nor expected the vehemence and cause.
Now that the first dust is beginning to settle, it is becoming clear that stock markets began to wobble in the US when equity investors finally came to realise that the return of more normal levels of interest rates and yields are the inevitable consequence of consistently improving economic condition worldwide which had given them ever improving corporate profitability. This wobble, or slight increase in market volatility led to a chain reaction that was triggered by derivatives based retail investment products whose returns were tied to and geared around low levels of volatility. When volatility exceeded certain thresholds, they become forced sellers of stocks to cover their exposures, while all more fundamentally based (human) investors were unwilling to buy their excessive volumes, given how expensive stock had recently become (again see chart above – last 6 weeks).
What followed was what can only be described as a flash crash, given how quickly equity prices collapsed back to where they had been trading at the end of last year. At those levels, valuations were no longer as extended, which brought back the fundamentally driven buyers and resulted in a gradual stabilisation of markets. We have dedicated a separate article to the dissection of the causes of the flash crash, written by our market trading expert Sam Leary.
The difficulty investors now face is to decide what is likely to happen as a consequence of this violent dislodging of the previous trend order. Firstly, market earth quakes as we just experienced tend to be followed by further tremors as witnessed Thursday and Friday. Secondly, the eruption of market volatility can lead to a fundamental market reassessment by investors leading to a break from the previous trend and finally, the sell-off itself can create a negative feedback loop into the real economy, with the potential to disrupt the previous economic balance or trend.