Traders Bemoaning Lack of Shock, Awe in Markets Finally Get Some

  • Friday’s selloff has traits common with past volatility shifts
  • Investors enduring a third day of elevated turbulence.

What Drove the S&P 500 to a Two-Month Low?

Traders who complained all summer about markets stuck in a zombie state are getting what they wanted, and probably will be for a while.

Eruptions of volatility this big rarely go away quickly. By one measure, the selloff ripping equities represents the sixth most violent rupture to market calm in history, with the S&P 500 Index’s drop of 2.5 percent exceeding its daily move in the prior month by a factor of 10. Every time that happened in the past, turbulence took its time petering out.

Patterns like that may affirm the view of bears who spent July and August warning that the peace blanketing everything from equities to bonds and currencies was likely to end in a bang, not a whimper. Of particular concern right now is the concerted nature of the selloff in which markets that don’t ordinarily move in the same direction suddenly are.

“When investors come back from the beach and start thinking about, ‘How am I going to prepare for the fourth quarter?’ we’re going to see a lot of activity,” said Brad McMillan, chief investment officer of Commonwealth Financial Network in Waltham, Massachusetts, which oversees $100 billion. “Volatility doesn’t go away. It gets stored up.”

Stocks and bonds plunged in tandem for the second time since Friday, driving measures of volatility higher as investors lost confidence central banks still have ammunition to promote growth. U.S. stocks notched their third straight move of at least 1 percent after 43 days without one, while Treasury yields were jolted out of the tightest monthly range in a decade. Oil joined the selloff, punishing currencies of resource exporters and leaving investors with few places to hide.

S&P 500 futures rose 0.2 percent at 7:22 a.m. in New York, while 10-year Treasury yields were little changed at 1.71 percent.

Among the pressure points:

  • Lockstep drops. A gauge tracking hedge fund strategies that balance bets over markets, the Salient Risk Parity Index, plunged the most since August 2015 on Friday.
  • Tepid data. Bloomberg’s index of economic surprises turned negative for the first time since July.
  • Earnings estimates. Analysts see S&P 500 profits falling 1.4 percent in the third quarter, almost double the drop they saw a month ago.

“People are certainly on edge around here,” said Robert Pavlik, who helps oversee $9.1 billion as chief market strategist at Boston Private Wealth. “The one saving grace is that we as a firm have some cash on the sidelines, but that doesn’t do any good when you’re still 90 percent invested in equities. You can’t help but feel some pain.”

Two months of tranquility was pierced Friday when the S&P 500 tumbled in its worst rout since the U.K. voted to leave the European Union. Angst as measured by the CBOE Volatility Index climbed 21 percent as of 4 p.m. in New York Tuesday after increasing Friday by 40 percent, its biggest gain in three months.

Things aren’t any better in the $13.6 trillion Treasury market. Ten-year notes were stuck in their tightest monthly range in a decade up until September, while implied volatility in global currencies was near the lowest this year before surging at the quickest pace since the June 23 Brexit referendum, a JPMorgan Chase & Co. index showed.

For bond traders at Pioneer Investment, the stress represents vindication. The firm has been betting against longer-dated Treasuries, a losing trade for most of this year until last week.

“We were very pleased that the strategy finally seems to be working,” Paresh Upadhyaya, director of currency strategy in Boston at Pioneer, which oversees about $236 billion. “Is the global rise in yields a structural change, meaning we’ve seen the bottoming in yields or is this another head-fake that’s roiled fixed-income from time to time? This time feels different.”

Stocks exited the tightest trading range in history last week when European Central Bank President Mario Draghi downplayed the need for more measures to boost growth and Boston Fed President Eric Rosengren warned against waiting too long to raise interest rates. While equities rebounded after Fed Governor Lael Brainard urged prudence in raising rates, they succumbed anew Tuesday with valuations sitting near the highest level in more than a decade.

“Everyone was out for the summer. Now all of a sudden people are asking ‘Are they going to raise interest rates?”’ said Bruce Campbell, fund manager with StoneCastle Investment Management in Kelowna, British Columbia. His firm manages about C$100 million. “People were running out on Friday, then they were running back in yesterday, now they’re running for the exits again today. It’s a crazy, bipolar stock market.”

Such abrupt breaks in calm have not been easily resolved in the past. In the five prior instances when turbulence spiked as it did Friday, the S&P 500’s daily swings averaged 1.5 percent in the next 20 days. That’s 2.5 times the move in the previous 20 days, data compiled by Bloomberg and Bank of America Corp. show.

Markets look fragile, Bank of America analysts led by Abhinandan Deb wrote in a note to clients Tuesday. “We believe a bona fide bond shock remains a key destabilizing risk to markets, particularly if catalyzed by a loss of confidence in central banks.”

It’s been a while since a protracted decline took hold. Following Britain’s decision to exit the European Union, the S&P 500 dropped 5.3 percent over two days, only to rally the next four and erase the entire plunge two weeks later. Two 10 percent corrections that began in August 2015 and January 2016 also proved short-lived.

That’s not to say that stocks will follow the same route this time. With S&P 500 profit in the worst decline since 2009 and presidential elections looming, the list of reasons for the second-longest bull market to strengthen is getting shorter. While improved economic data helped fuel the S&P 500’s 20 percent rally from a February low, signs of weakness are emerging.

All year bulls have pointed to an element missing from market psychology and said it would prevent a full-blown selloff -- overconfidence. But signs of exuberance have been multiplying in the market, including record high levels of bullish holdings by hedge funds in index futures contracts and unrepresented short positions in VIX futures.

“There is just this steady crowding into stocks because that’s the only place to generate returns. That’s a pretty complacent approach,’’ said Eric Schoenstein, Portland, Oregon-based co-manager of the $5.4 billion Jensen Quality Growth Fund. “When you take your eyes off the potential for risk, that’s when you can really get harmed as an investor.’’

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