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An Aftershock In Store

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: John M. Mason
Summary

I must admit that with all the increases in uncertainty that have taken place recently, I am somewhat edgy about the current situation in the financial markets.

Historically, August has not been the best month in the year for the stock market and the increased uncertainty has certainly resulted in greater stock market volatility.

Tuesday, U.S. stock markets rebounded from Monday's losses. That may continue for a while but one needs to realize that sometimes, historically, the recovery has been followed by an aftershock.

The following headline bothered me:

Beware of 'Lehman-like' Aftershock to Stocks.”

Matthew Rocco writes in the Financial Times,

A recovery in US stocks on Tuesday could merely be the calm before the storm…brace for a possible "Lehman-like" aftershock following Monday’s broad sell-off.

The possibility discussed is a potential spike in volatility to arrive in two waves” which includes “sell-offs that historically occur in August” and “selling by hedge funds and trend-following algorithmic traders.”

The latest movement in stock prices has been accompanied by a rise in the VIX volatility index above 20.00.

One week ago, the VIX volatility index was below 13.00. The measure has not been around the 20.00 level for a long time.

Mr. Rocco makes sure that we know that this index has been referred to as Wall Street’s “fear gauge.”

And the second wave?

Mr. Rocco quotes Masanari Takada from Nomura Securities:

…the second wave may well hit harder than the first, like an aftershock that eclipses the initial earthquake. At this point, we think it would be a mistake to dismiss the possibility of a Lehman-like shock as mere tail risk.

Mr. Takada is referring to when the Lehman Brothers investment bank collapsed during the financial crisis in 2008.

And it is not unusual for investors to come back into the market following a substantial downward movement like has taken place recently.

The urge is to buy back in.

The stock market has been rising for 10 years, hitting new historical high after new historical high.

But, that was when the Federal Reserve was underwriting the rise in stock prices.

Things have changed.

This is what I have been writing about recently.

The relationship between Federal Reserve monetary policy and the stock market may have been disrupted.

Now, the Federal Reserve may be faced with a situation in which it is forced to lower its policy target for the federal funds rate in order to keep the U.S. dollar weak against the currency of other major nations because the central banks connected with these major nations need to keep lowering their policy rates of interest to support the weak economies of these nations.

The cloud hanging over all of this is the one that has arisen due to all the threats that are flying around the world concerning tariffs battles and trade wars.

The possibility of a currency war following along after the trade wars has suddenly become a reality with China moving to where it takes 7 Chinese yuan to purchase one U.S. dollar. The U.S. government has already claimed China to be a currency manipulator.

But the European Central Bank has also indicated that it is preparing to lower its policy rate again. And President Trump has accused the ECB of being a currency manipulator.

The focus of monetary policy has changed and, to many, it appears as if the Federal Reserve has lost control of its conduct of policy. The Federal Reserve may just have to follow allow as other countries make their moves.

The consequence of this is that, as I have just written, is that “Uncertainty Rules”.

And, as uncertainty rules, volatility increases.

No one likes uncertainty. In an uncertain world, no one really knows what is going to happen. In an uncertain world, investors are jumpy and move this way or that way for the slightest reasons.

I am not saying that there will be an aftershock that will shake the world.

I hope that there is not an aftershock that shakes the world.

It is just that with the rise in global uncertainty, the possibility that an aftershock might take place has increased.

It’s August. One needs to be on guard for a stock market correction. And, like I wrote in the first sentence of this post, the headline “Beware of Lehman-like Aftershocks to Stocks” bothered me.

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.