Things to remember after a wild market

New York (Oct 22)   Many investors will remember last week’s market gyrations (and Wednesday’s in particular) as exceptional, exciting, frightening and draining. The wild movements affected both stock prices (including a 600-point swing in the Dow Jones Industrial Average in just a half-hour), as well as US treasury bonds, which are traditionally more stable and reassuring.

Yet the relevance and consequences of the week’s extreme market fluctuations extend far beyond investors and traders to include the prospects for economies as a whole. The interrelated lessons also suggest that, looking forward, these market gyrations may not prove that unique.

Here are four noteworthy lessons to be drawn from last week:

n It doesn’t take much to severely dislocate markets, both down and up. It is hard to point to a single cause of last Wednesday’s harrowing fall in equities and the eye-popping rise in government bond prices.

Instead, a set of rather small things led to a tipping point, catching many in the marketplace (and outside) by surprise.

While the markets’ impressive countermoves on Friday were widely attributed to a single factor – reassuring words from Federal Reserve (Fed) officials that they would maintain a highly accommodating monetary policy – this seems rather narrow in the bigger context of what’s going on in the global economy.

n Liquidity is elusive when traders need it most, even when it comes to the deepest of all markets. Much of the jerky and extreme price movement can be attributed to the lack of market liquidity.

Gone are the days when broker-dealers would limit disruptive volatility by keeping unwanted but fundamentally sound positions on their balance sheets, rather than joining others in dumping them. Today, markets have little counter-cyclical ability to absorb these risks.

Too large a segment of the investment community is in crowded trades that provide excessive collective solace when the going is good, but act like roach motels when the tide turns.

n Market positioning and related risk-taking are no substitute for solid fundamentals. Driven by risk-taking, which has repeatedly rewarded investors in recent years, prices in certain market segments have been taken to levels that have become decoupled from investment fundamentals.

Lacking a sound footing, the markets become overly sensitive to unanticipated news, such as the Ebola epidemic or, with the exact opposite effect, to suggestions that the Fed could slow its exit from its third round of quantitative easing.

The resulting fluctuations are then greatly amplified by patchy liquidity and crowded trades.

n The Fed still doesn’t have much appetite for financial volatility, and markets will readily embrace its reassurances that it will try to act to counteract these gyrations. It didn’t take long for Fed officials to respond to last week’s volatility in an effort to calm the markets.

The response came in the form of suggestions that, by maintaining its monthly securities purchase programme for a bit longer, the Fed could slow its retreat from a highly accommodating monetary policy.

This was music to the ears of investors who are now conditioned to depend heavily on Fed support. By the end of the week, some were even suggesting that the Fed could embark on a fourth round of quantitative easing, to artificially support asset prices.

Together, these four lessons suggest that, rather than being a one-off event, last week’s volatility is better seen as an indication of what may lie ahead – unless countries can make profound and durable improvements in their economic and political fundamentals. 

Source:  Bloomberg