If the wild swings in the stock market don't make much fundamental sense to you (400-point drop in the Dow anyone? Anyone?), there's a pretty good reason: They don't.
Sure, oil has everyone running scared, but there's something else going on as well. Trading volume in U.S. stocks picked up in 2015, reaching the highest level since 2011. But it wasn't exactly due to Graham & Dodd-style fundamental stock pickers. Volume from actively managed funds has declined over the last decade as high-frequency trading and index funds grew steadily. Average daily volume increased noticeably last year even as trading by active funds held steady, according to data from Credit Suisse analyst Ana Avramovic:
This is hardly breaking news, but keep in mind that much of the volume considered "active" is probably not what many of us think of as active stock picking. It encompasses newer automated strategies that chase momentum and trends or react to changes in volatility, so the amount of real-time human judgment involved is probably even less than what the chart shows, especially if you don't put a lot of faith in the risk-on, risk-off impulses of the indexing crowd.
This didn't cause a lot of problems when stock indexes were slowly marching higher during much of the bull market, but that regime may have ended in August and carried over into this year. What may have ensued is sort of a mosh pit of electronic trading that can crowd all the fundamental waltzers right off the dance floor. Eventually, one hopes, the moshers tire themselves out and the waltzers return to the floor and push the market back where it belongs, or at least nudge it in the right direction so that the automated momentum chasers take it the rest of the way.
Could that happen? One would hope. But Mohamed A. El-Erian of Bloomberg View makes an excellent point:
But volatility does matter to investor positioning, risk appetite and the formation of price expectations. And the longer it lasts, and especially if it is the “volatile volatility” of recent weeks, the more likely it is to be accompanied by a durable decline in markets overall.
And there's something else to note about the pickup in volume. It may not be a sign of the type of liquidity that's likely to act as a shock absorber against wild market swings. According to strategists at JPMorgan, who have shown they know a few things about the nonfundamental issues affecting the market, it's the market depth that matters:
Market depth measures how many contracts can be bought or sold before moving the market ~1 point. While equity volumes look robust, market depth continues to trend lower. Over the past 2 years, the market depth has declined by more than 60%, reducing the market’s capacity to absorb large shocks — as was illustrated during the August 24th crash.
This is not to say that there aren't legitimate concerns -- lack of profit growth, oil, China's slowdown, weakness in credit markets -- that are helping drive stocks lower. But the violence and suddenness of the swings don't necessarily have much to do with the fundamentals.
Unfortunately, the wild swings could be the "new normal," at least for the near future. From a note on Tuesday from the JPMorgan strategists: "Prepare for a structurally higher volatility environment and, importantly, higher market tail risk. We expect periods of quiet market followed by periods of abrupt sell-off like the one we are witnessing YTD and also saw last Aug."
In other words, keep those seat belts buckled.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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Michael P. Regan in New York at firstname.lastname@example.org
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