Understanding This Markets Rout -- Update

02/09/18 05:20 PM EST
By Jon Sindreu and Mike Bird 

U.S. stocks sank into correction territory Thursday for the first time since 2016, yet many investors still don't understand what's driving the rout.

While fears about inflation and rising bond yields have played a role, markets aren't behaving as they usually do during big equity selloffs. That could point to a market still driven by the aftershocks of misfired bets on low volatility, rather than a reappraisal of the global economy.

While the volatility-trading shakeout may bring further bouts of pain, stock markets will recover and continue to do well against a backdrop of healthy economic growth and strong earnings, many analysts say.

Here are some of the mysterious market moves that point that way:

Volatility prompted more selling

The hardest-hit investors have been those who were betting against swings in the U.S. stock market, often through the Cboe Volatility Index, or VIX. When equities dropped, the VIX surged.

But aside from taking their own losses, they may also have turned a small slump into a full-blown correction. Research suggests that short-volatility strategies can fuel drastic reversals in stock markets as investors scramble to offset the damage either by buying back the asset they sold in the first place -- in this case, volatility through futures -- or selling stocks, which drop as volatility increases. This means the wider stock market is overwhelmed by sellers.

In a note on Friday, UBS said the VIX's record percentage jump Monday was "extremely rare" by historical standards, even for a day when the stock market fell 4%.

Some selloffs are equal

One key sign that investors are still cleaning up after their misfired volatility bet is that Thursday's selloff looked quite similar to Monday's, when the VIX first blew up.

In the 80 days before this week's rout, an average down day on the S&P 500 would lead the index to slide gradually lower, market data show. But Monday's and Thursday's selloffs were marked by sudden plunges as trading came to a close, which is when many investors need to rebalance their exposures.

UBS data show that volumes in VIX futures surged at the same time.

"When you have bouts of volatility, they don't usually last one or two days. They can last weeks to months," said Lance Humphrey, executive director of global multiasset for USAA Asset Management.

Indeed, some analysts estimate that about $250 billion in equities need to be sold before volatility-targeting investors can rest easy. A note from JPMorgan Chase & Co. analysts on Friday suggests most of that amount has already been done.

When investors sell because they are re-evaluating just how good earnings and the economy will be, some sectors will typically suffer more than others. But this isn't happening now.

Broad-based selling

"The stocks which have gone up the most, you would expect to be falling the hardest," said Eoin Murray, head of investment at Hermes Investment Management.

On the way up, the MSCI USA Cyclical Sectors Index -- which includes stocks that outperform as the economy improves, such as banks -- rose by nearly 30% in the year to Jan. 26, when U.S. stocks peaked.

Defensive sectors, which typically outperform in tougher times, rose by around 16% in the same period.

During U.S. equity-market corrections in late 2015 and early 2016, cyclical stocks drastically underperformed defensive stocks. But this time around, the two have been falling almost in tandem. In fact, cyclical stocks have declined slightly less.

Bespoke Investment Group says that this selloff has been indiscriminate, with selling across companies, regardless of their sector, size or earnings prospects. U.S. financial firms, which in theory would benefit most from higher interest rates, have been the second hardest-hit over the past week.

Riskier markets holding up

So far, the downturn has affected stocks and left many other markets mostly unruffled, which shouldn't happen if investors are truly concerned about the economy. Even markets and assets that are perceived as being risky aren't being hit the hardest.

Take Italy. Its flagship equity index is one of the few globally that is still in positive territory this year. Based on how Italian stocks usually react when people sell elsewhere in the world, these shares should have sold off by around 2 percentage points more than they did between Jan. 26 and Feb. 6, according to Goldman Sachs.

In one key measure of how investors judge Italian risk, spreads between 10-year Italian sovereign-bond yields and ultrasafe German bunds hit 1.26 percentage points on Thursday, the narrowest gap in around 16 months. Yet, Italy goes to the polls on March 4 for an election that last year was seen as being one of the big risks in European markets.

Many other markets also aren't conforming to the idea that investor sentiment has turned. Havens such as German government bonds or gold, which should do well when money managers are jittery, have edged down during the past week.

Yet riskier assets such as junk bonds and some emerging markets have weathered the blow unexpectedly well.

Write to Jon Sindreu at jon.sindreu@wsj.com and Mike Bird at Mike.Bird@wsj.com


(END) Dow Jones Newswires

February 09, 2018 17:20 ET (22:20 GMT)

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