The Case for Chaos in Trying to Pick Bottom of U.S. Equity Rout

  • `Wholesale panic' could bring relief to U.S. stocks: Minerd
  • Better-than-expected earnings could help market find bottom

Market Turmoil: Are Investors Overreacting?

In a market bouncing up and down 2 percent a day, investor psychology is taking a beating in U.S. stocks. But nerves may need to fray further before the volatility abates.

For all of last week’s twists, measures of investor anxiety sit well below levels from the last selloff, when shares plunged 11 percent in August. Twice last week the Chicago Board Options Exchange Volatility Index jumped more than 10 percent in a day, yet it ended 34 percent below its summer high.

To those who monitor sentiment for clues to the market’s direction, these aren’t things that add up to capitulation, when bulls give up and prices fall to levels where calm is restored. While last week’s losses capped an 8 percent tumble that equaled the worst start to a year on record, they see enough optimism left to keep gyrations coming.

“Wholesale panic” is what’s needed before the market turns, according to Scott Minerd, who oversees $240 billion for Guggenheim Partners LLC,. “You start to see a huge surge in volatility because everybody is just trying to get through the exits, and they’re pushing prices down just to get out of the positions.”

Ten days into 2016 and more than $2 trillion has been wiped from American stocks, with the Standard & Poor’s 500 Index careening to the lowest close since August. Alternating swings in the Dow Jones Industrial Average over the last three days were the wildest since S&P stripped the U.S. of its AAA credit rating in 2011.

The Chicago Board Options Exchange Volatility Index, a gauge of trader trepidation tied to options on the S&P 500, ended the week at 27.02, more than 60 percent above its average level in 2015. At the same time, it sits 12 percent below its mean reading during the six-day rout that started Aug. 18 -- and 34 percent below its highest close in that stretch.

Looking deeper into volatility markets, data compiled by the Commodity Futures Trading Commission show that hedge funds and other large speculators bet against more gains in the VIX last week, with a net short position of about 6,500 futures.

Part of the reason for the divergence is that many traders find the selloff hard to explain, according to Russ Koesterich, global chief investment strategist for New York-based BlackRock Inc., which manages $4.5 trillion. Particularly baffling is the spell oil has cast on stocks, with some of the biggest equity selloffs of the last two week’s coming as Brent crude flirted with $30 a barrel.

“It’s not obvious why oil is driving the market and I think everyone is trying to understand that,” Koesterich said. “If commodities are falling this rapidly, are they the canary in the coal mine, and what do they tell us about the U.S. economy? But the drop in oil is completely driven by excess supply.”

Whatever the cause, pain is spreading, with every industry except utilities down in 2016, including losses of 8 percent or more in industrials, consumer discretionary, energy, technology, banks and materials. Only 39 stocks in the S&P 500 are showing gains for 2016.

“The market is manic depressive and it swings from seeing only the positives to seeing only the negatives,” Howard Marks, a co-founder of Oaktree Capital Group LLC, the world’s biggest distressed-debt investor, said in an interview Friday on Bloomberg Television. “Maybe it has to get dramatically undervalued, which means it swings too far to the negative.”

Should sentiment alone fail to arrest the selloff, investors will focus on a handful of things that have so far failed to keep stocks from falling -- from earnings to valuations and levels on charts. The S&P 500 ended last week trading at 16.8 times profits, down from 18.8 as recently as November.

With more than 40 members of the S&P 500 scheduled to report quarterly earnings in the week starting Tuesday, positive results could provide a temporary bottom for U.S. equities, said Quincy Krosby, a market strategist at Prudential Financial Inc., which oversees about $1.2 trillion. Companies in the gauge are forecast to say profits slid 7 percent in the fourth quarter, the most since 2009.

The S&P 500 ended Friday at 1,880.33 after sliding as low 1,857.83 earlier in the day. For chart-watchers, now that August’s low of 1,867 has been tested a fourth time since 2014, “1,800 might come pretty quick,” said Ryan Larson, the Chicago-based head of U.S. equity trading at RBC Global Asset Management Inc., which oversees $280 billion.

That’s a level that makes sense to Jim Paulsen, the Minneapolis-based chief investment strategist at Wells Capital Management Inc., which oversees $351 billion.

“What this correction is about is finding the new valuation level that’s sustainable in the face of the new pressures that the market is going to face now that the U.S. is growing at full employment levels,” he said. “My work leads me to about 16 times earnings, which would be right at 1,800 or a little less.”