When good news equals bad news
The crash began last 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.
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.
Interestedly, 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.
The most convincing argument for the sudden drop in stocks
It’s 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.
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.
How you can protect and prosper through volatility
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 my stockmarket warning. It contains my plan to keep your wealth protected and growing, whatever transpires. Click here to read it.
Always remember, knowledge brings you wealth,