The market swung from record heights to “correction” within a mere six days.
Only once in history has it plunged so violently so swiftly. In 1928 that was — not long before the great gale of ’29 blew on through.
The market has since endured 25 “swift” corrections over 75 years.
These are not extended, orderly retreats. They are rather lightning hysterias packing ferocious wallop.
On average — the phrase is necessary — you can therefore expect one of these frantic corrections every three years.
Yet four of these 25 hair-raisers have shaken Wall Street since August 2015.
That is greater than once per year — again, if you take the average.
(We doff our cap to macroeconomic analyst “The Heisenberg” for supplying the data.)
We must conclude the market is increasingly vulnerable to these sudden and violent shakings.
But why? Why the greater frequency since 2015?
Today we seek to drive a light through the puzzle… and penetrate the mystery.
But first, how did battered markets open the fresh week?
Stocks Roar Back
Dow Jones futures swung dizzily in overnight trading Sunday — over 1,000 points peak to trough.
Greater volatility, that is, was likely on tap this week.
But like a careening drunk who grabs something sturdy on the way down… the stock market steadied itself today.
Steadied itself? It went bounding up the nearest tree…
The Dow Jones vaulted 1,294 points today, regaining a healthful chunk of last week’s losses.
The S&P recaptured 136 points; the Nasdaq, 385.
Market-maker Apple recovered 6% this morning. The “FAANG” stocks also climbed to their feet today.
The Return of the “Dip Buyers”
Thus the “dip buyers” peeked out from their bunkers today… and concluded it was safe to come out.
Explains Brent Schutte, chief investment strategist at Northwestern Mutual:
“The sell-off was so fierce last week that you do have some buy-the-dip investors emerging.”
We suppose the immediate prospects of rate cuts put some heart into them.
Markets presently give 100% odds of a March rate cut. And not a 25-basis point rate cut… but a thumping 50-basis points.
And an April rate cut? Those odds exceed 70%.
Yet the bond market dismissed entirely the promise of additional empty fireworks…
The 10-year Treasury yield once again plummeted to record depths today, to 1.065% — a sweet distance below its July 2016 low of 1.27%.
Gold, meantime, surged $22.30 today after last week’s savaging. Perhaps it is poised to reclaim its “safe haven” mantle.
But returning to our central question… why are corrections growing more violent?
A Likely Answer
We believe “passive investing” holds the answer — or much of the answer.
As we have written before…
After the 2008 near-collapse, the water management team at the Federal Reserve inundated markets with oceans of liquidity.
The biblical-level flooding knocked down existing financial signposts. And “fundamentals” no longer seemed to matter.
The tide was rising — and all boats with it.
“Active” asset managers casting the water for losers hauled up empty nets.
Some 90% of all actively managed stock funds have underperformed their index during the last 10 years.
“Passively” managed funds — on the other hand — make no effort to pinpoint winners.
They instead track an overall index or asset category, not the individual components.
They are “passive” because they sit back on their oars… and let the flowing tide lift their boat.
Passive Investing Has Yielded Handsome Dividends
This strategy has yielded handsome dividends this past decade of generally rising waters. Tim Decker, president and CEO of ISI Financial Group, explains:
Passive management came into its own during the long bull market that started in late 2009, after the market had collapsed amid the financial crisis in 2007–08. Money had been flowing from active to passive vehicles in the preceding years, and investors — disillusioned by their losses in the crisis and the high fees they had paid — started turning to passive vehicles even more. That trend has continued to this day.
Passive investing has increased from 15% of funds in 2007 to perhaps half today.
Wall Street has poured into titanics like Facebook, Apple, Alphabet (Google), Netflix and Microsoft.
Their combined tonnage presently exceeds 10% of the stock market’s overall $34 trillion heft.
As long as the tides continue rising….all is peace.
But here is the risk:
When the tide recedes… that same handful of stocks can wash the market instantly out to sea.
For when they move, the market goes with them.
Panic selling begets panic selling. And none knows how far the waters might drop.
All Heading for the Exits at Once
Explains Jim Rickards:
In a bull market, the effect is to amplify the upside as indexers pile into hot stocks like Google and Apple. But a small sell-off can turn into a stampede as passive investors head for the exits all at once without regard to the fundamentals of a particular stock…
Or as analysts Lance Roberts and Michael Lebowitz of Real Investment Advice have it:
When the “herding” into ETFs begins to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures.
Importantly, as prices decline it will trigger margin calls, which will induce more indiscriminate selling… As investors are forced to dump positions… the lack of buyers will form a vacuum causing rapid price declines [that] leave investors helpless on the sidelines watching years of capital appreciation vanish in moments.
“Fast, Furious and Without Remorse”
These fellows remind us that investors hemorrhaged 29% of their capital over a three-week span in 2008 — and 44% over three months.
“This is what happens during a margin liquidation event,” they conclude.
“It is fast, furious and without remorse.”
Last week’s selling was fast… furious… and without remorse.
Microsoft plunged over 20% at one point last week, for example — as did Apple. Thus they were dragged into bear market regions, however briefly… defined as a 20% drop from their recent heights.
Facebook and Alphabet, meantime, posted double-digit losses.
And given their overall tug on markets… last week witnessed a thumping correction.
Why Should They Stop Now?
Again, only in 1928 did stocks plunge from record heights into correction in merely six days.
Goldman, in summary:
“Narrow bull markets eventually lead to large drawdowns.”
We do not know which direction the markets will take next. And we will hazard no prediction — as we have limited appetite for crow.
We will only say that deceased felines have been known to bounce.
But to our notion, passive investing at least partly explains these intensifying market spasms.
And we expect more of them.
Our concern is that the market may fall into spasm one day… and fail to come out.
Managing editor, The Daily Reckoning