Experienced investors understand how hard it is to call a bottom.
As U.S. stock markets conclude one of the wildest and worst weeks since the global financial crisis, here are 10 things to know about the sell-off:
- It is driven by technicals, not fundamentals. The ongoing market correction doesn't reflect a worsening of economic and corporate fundamentals. Rather, it is being driven by technical factors, including the unwinding of "short-volatility" trades (more on these below), the testing of relatively new products and a shift in investor conditioning away from the "buy-the-dip" paradigm.
- It is inherently unsettling. One of the reasons why this sell-off is so unsettling is the difficulty of pointing to familiar culprits, be they economic, geopolitical or corporate-related. This makes investors and traders more jittery, more suspicious and less confident about what will happen next.
- Diversification is not translating into risk mitigation. Government bonds, the traditional "safe assets," have not provided any meaningful risk mitigation, which adds to investor discomfort. Indeed, rather than increase in price, some have declined concurrent with the sell-off in "risk assets."
- It follows a highly unusual period. The sell-off follows an atypical time of extremely low market volatility and stocks that seemingly only go up. Before the recent turmoil, U.S. stocks went more than 400 days without a 5 percent drawdown and, in 2017, the Dow Jones Industrial Average registered more than 70 highs.
- It is characterized by an unwinding of the short-volatility trade in its many forms.The main technical driver is an unwinding of short-volatility positions. Some of these were taken directly through relatively new products, such as those that offer investors the inverse of the move in volatility indexes like the VIX. Some were constructed via derivative positioning. And some reflected the extent to which investors departed from their natural investment habitat, stretching far and wide for returns. In some cases, this was turbocharged by leveraged positions that, once volatility spiked, triggered margin calls that forced investors to sell a wide spectrum of holdings.
- It is global rather than domestic. Although some have been tempted to blame U.S.-specific factors such as the increase in the government budgetary funding requirement and the latest wage data, few market indicators support this view (particularly when it comes to interest-rate differentials across advanced economies). Indeed, the signals from interest rates around the world point primarily to higher global growth and inflation.
- It changes investor conditioning. It is not surprising that these developments have severely reduced, at least for now, what was a very strong appetite to "buy the dip," regardless of its cause. Instead, investors with cash on the sideline are waiting for the technicals to play themselves out. The more experienced market participants are acutely aware of the difficulty of calling a bottom when forced deleveraging and other selling pressures are at work.
- It is unlikely to contaminate the economy. Technicals-driven sell-offs don't have to spread to economic and corporate fundamentals. This is particularly the case in the context of a growing economy, strong corporate balance sheets and prospects for pro-growth measures.
- It is unlikely to deter the careful and measured removal of monetary stimulus. As comments this week from Federal Reserve officials and signals from the Bank of England demonstrate, central banks do not see the market turmoil derailing their gradual normalization of monetary policy.
- It can put markets on a firmer footing. Although it is painful in the short-term, this correction could underpin healthier markets in the longer-term. It reminds participants of the importance of respecting, and better pricing, volatility and liquidity. And, with improving actual and prospective growth, the sell-off can be part of a transition from liquidity-driven valuations to ones built on better economic and corporates conditions, thereby narrowing the gap between elevated asset prices and fundamentals -- and the concern for future financial stability that comes with such a gap.
This article originally appeared on Bloomberg View.