Dear Algos: Thanks for the Tantrum. Love, Mom and Pop
After a temper tantrum like the markets threw on Friday, it's natural that every little pebble now appears to be the size of a boulder.
And as usual, there are plenty of boulders: High valuations, disappointment with the European Central Bank's decision to play down the need for more stimulus last week, seasonal weakness in September, continued hawkish comments from Federal Reserve officials, concern that profit expectations are too optimistic again, the slow but relentless creep higher in Libor, to name just a few.
After the selloff, you can throw in a larger serving of political uncertainty as Hillary Clinton's health became a chief focus over the weekend, and Donald Trump turned his mouth of mass destruction toward Fed Chair Janet Yellen.
And perhaps the biggest pebble of all may be the sense that once volatility is reintroduced to the market, it could be up to a cabal of price-insensitive computer programs to determine how bad the dip gets, how long it lasts, and if and when it will be bought. As JPMorgan Chase's quant guru Marko Kolanovic warned last Wednesday, the tranquil markets of the summer caused a binge among systematic funds that chase trends and embrace low volatility:
Given the low levels of volatility, leverage in systematic strategies such as Volatility Targeting and Risk Parity is now near all-time highs. The same is true for CTA funds who run near-record levels of equity exposure.
The leverage in these strategies and the effects of hedging in options markets that fed the tranquility was a recipe for a jump in volatility that didn't even need a new catalyst apart from an increase in price swings that's common in September and October, Kolanovic said.
In a world dominated by blissfully agnostic indexers and computerized strategies that, in aggregate, can still make markets move in mysterious ways, it does raise the question of how much the human stock picker's ballot counts in the proverbial voting machine of the market.
For what it's worth, retail investors appeared eager to play the part of contrarian on Friday as everyone else was selling, at least according to a compilation of activity on Fidelity's website. As prices plunged, customers of the brokerage were net buyers of shares of Amazon.com, Facebook, Apple and ETFs that track the S&P 500 and financial shares, while taking advantage of the surge in the VIX gauge of volatility to dump shares of exchange-traded products tied to it:
Retail bought the dip, even though a lot of the "smart money" set was advising to stay away for now. With stocks showing signs of recovery on Monday, mom and pop looked sage. Only time will tell whether they stay that way.
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