I appreciated El-Erian’s measured reflective demeanor and honest considered comments regarding the recent stock market sell-off in his Bloomberg article republished February 11, 2018 at SA (10 Things To Know About The Stock Market Sell-Off). The article helped me organize my thoughts about what has happened in the economy, what is happening in the economy and what might happen going forward. Here are my comments and observations regarding the recent sell-off using El-Erian’s 10 points as a road map.
- It was triggered by technicals and driven by fundamentals. The ongoing market correction is driven by fundamentals (that might matter again). The technical trigger is related to reaching an event-horizon for starting the unwinding of the short-volatility trade and breaking “reflexivity” regarding the same. The short-volatility trade is a bet on lower and lower volatility for longer and is an emergent property in some respects from “lower interest rates for longer” conditions. The actual trigger for the unwind was a spike in volatility that was for some reason not sufficiently and immediately shorted this time. I agree with El-Erian that the ongoing sell-off is being driven by a shift in investor conditioning away from the “buy-the-dip” paradigm.
- It is inherently unsettling - particularly for investors that primarily follow the mainstream financial media. One of the reasons why the sell-off is so unsettling is the blindness of investors to familiar culprits in plain sight, be they mounting trade deficits, perpetual budget deficits, monumental levels of debt, or massive debasement of fiat currency. This blindness no doubt makes investors and traders more jittery, more suspicious and less confident about what they are being told will happen next.
- Diversification is not protection against the everything bubble in bonds, stocks and real estate. The realization that government bonds, the traditional “safe assets,” will not provide any meaningful risk mitigation adds discomfort to investors that do not understand or care that lower interest rates for longer monetary policy changed the normal paradigm. The previous paradigm was that bonds were safe and stocks were risk assets, whereby the former went up when the latter went down and vice versa. The flood of low quality liquidity changed the paradigm to either “everything up” or the corresponding reverse “everything down” (see this SA article from Epoch Times by Valentin Schmid for additional discussion of the “everything up” concept).
- If follows a highly unusual period of lower and lower volatility for longer and a corresponding only up complacent stock market rise. It remains to be seen whether what follows will be an unusual period of the reverse.
- It is characterized by a spontaneous narrative inversion and new reflexivity that is now unwinding the short-volatility trade. The narrative inversion is that fundamentals matter again and conditioned buy-the-dip may not work anymore. Because the system was highly leveraged regarding using short-volatility ETFs, volatility derivatives, and general margin account speculation to stretch returns, then when there was a spike in volatility (that was not shorted sufficiently/immediately), it caused a short-squeeze (of short-volatility traders) that triggered margin calls that forced broader selling that increased volatility and created an escalating positive feedback loop.
- Yes, it is global rather than domestic. And is linked perhaps to a global USD de-dollarization trend, lower demand for U.S. Treasuries, rising interest rates and rising inflation, that is similar to what occurred leading up to the Nixon gold-shock in 1971 (See Wikipedia for general discussion of Nixon gold-shock).
- Yes, it changes investor conditioning. The factual predicate (whatever it maybe) that conditioned and supported the aggressive investor buy-the-dip strategy seems to be absent right now. Some investors on the sidelines may be waiting for a signal from the Fed to see when/if there will be a rescue (via flipping back to looser monetary policy). Forward thinking market participants are acutely aware of the increasing difficulty for the Fed to simply ride to the rescue and are perhaps thinking about the end game, and therefore not calling the bottom.
- It is likely to contaminate the economy. Because this is not simply a technicals-driven sell-off that can be easily dismissed and ignored, it is likely for there to be contagion to economic and corporate fundamentals that have their primary foundation on easy-money monetary policy supports that seem to be coming to an end (for now).
- It is unlikely to deter the careful and measured removal of monetary stimulus - unless the market unwind continues on pace or accelerates in which case there probably will be a chaotic impromptu flip-flop at the Fed that will attempt to revert to loose monetary policy, presumably without triggering further loss of confidence in the USD and U.S. government debt instruments.
- It can put markets on a firmer footing. In this regard, I wholeheartedly concur with El-Erian at the theoretical level. My sense is that the painful adjustment could be more than short term and/or more acute in order to reverse many years of malinvestment financed by low quality liquidity from loose monetary policy. If a more natural pricing of money can be allowed, it will send powerful signals for saving, efficient resource allocation, stimulation of productive consumption, creation of real durable wealth, and weeding out free-riding non-performing elements in the economy.
The market sell-off that started on Feb. 2nd may not be simply a technicals-driven sell-off that can be easily dismissed and ignored. The unwinding of the short-volatility trade was triggered by a spike in volatility (that was not shorted sufficiently/immediately) that caused a short-squeeze (of short-volatility traders) that then resulted in margin calls that forced broader selling, that increased volatility and created an escalating positive feedback loop. The sell-off was driven by fundamentals mattering again and by a shift in investor conditioning away from the “buy-the-dip” paradigm.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I currently have investments in the precious metals complex.