Trend Strategies seen Behind Massive Stock Market Selloff, Analysts say Event Likely to be Short-Lived

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The recent sell-off in global equity markets is not as sinister as some of the headlines suggest with some analysts expecting a recovery to ultimately shape up.

Global stock markets have endured a torrid 24 hours with one analysis suggesting that over $4 trillion were lost ahead of the attempted recovery which is underway at the time of writing.

The origin of the woes were the United States where the S&P 500 and Dow Jones Index sank by more than 4% at one stage as investors took fright and rapidly shed exposure to equities.

Analysis of the move lower conducted by JPMorgan suggests much of the selling can be laid at the door of automated trading decisions.

To understand the mechanics of the sell-off, one needs to look back to the origin of the action which can be found On Friday, February 2, when the market dropped ~2%.

"The move on Friday was helped by market makers’ hedging of option positions (as gamma
positions turned from long to short midday). Friday’s move, on its own, was significant as it pushed realised volatility higher, which is a signal for many volatility targeting strategies to de-risk," says Marko Kolanovic, who sits on the Global Quantitative Derivatives Strategy desk at JPMorgan.

Vix is now spiking to its highest since the Chinese currency devaluation of 2015 - worse than Brexit referendum, Grexit crisis, anything else in the last 5 years. That looks a tad overdone. pic.twitter.com/f7TfMCQle9

— John Authers (@johnauthers) February 5, 2018

Anecdotal evidence presented to Kolanovic suggests broad knowledge about the risk of systematic selling kept many investors fearful and waiting on the sidelines (both in equity and volatility markets).

Short-term momentum turned negative on Monday, February 5, "resulting in selling from trend-following strategies," says Kolanovic. "Further outflows resulted from index option gamma hedging, covering of short volatility trades, and volatility targeting strategies. These technical flows, in the absence of fundamental buyers, resulted in a flash crash at ~3:10pm Eastern Time.

At one point, the Dow was down more than 6%, before partially recovering.

Global Stock Market Rout Seen as Correctional, for Now

Most analysts however believe the decline seen on global stock markets over the course of this week is likely to be short-lived.

The decline in global stocks which started on Friday, February 2, represents a correction within the longer-term bull market we are told.

Triggering the selling of stocks was Friday's US employment report which showed stronger-than-forecast wage pressures which suggests to markets that US inflation is going to rise faster than they had initially anticipated. Stronger inflation would require a response by the US Federal Reserve by way of raising interest rates, which in turn tends to slow economic activity.

The Bureau of Labor Statistics announced on Friday that the US economy added more than 200,000 new jobs in January and that wages grew on average by 2.9%, this was the first time since August 2016 that jobs and wage growth numbers beat expectations simultaneously.

“The momentum since the start of the year has been bullish with equities pushing higher and the USD selling off. The honeymoon period for equities has now hit a question mark over potential rising borrowing costs. It can be argued that the bull run had ran somewhat ahead of sentiment with overconfidence creeping in. The higher wage inflation from US payroll data on Friday was the beginning of the doubts and this was enough to encourage some profit taking that has now spilled into a wider sell off," says Phil McHugh, Senior Market analyst at Currencies Direct.

However, analysts are in agreement that the selloff is likely to be temporary and consolidate in nature as the fundamentals underpinning the US and global economy are strong. Indeed, while the US is widely held to be late in an expansionary cycle, Europe and Japan are seen to be in early or mid-stages.

Thus, even were the US to experience a slowdown, the rest-of-the-world should carry growth.

"Irrespective of short-term market movements, we believe that we are returning to a more ‘normal’ cycle of higher yields and higher interest rates. The real question is whether this process will be orderly or disorderly. For now, our core view is it will be an orderly transition, as equity markets remain underpinned by solid global growth and strong corporate earnings," says Graham Bishop, Investment Director at Heartwood Investment Management.

Indeed, earnings in the US remain strong with nearly 50% of companies within the S&P 500 having reported results, with around 80% of those beating revenue expectations, which is the highest percentage since at least the third quarter of 2008.

“We remain reassured by the fact the actual inflation is still relatively subdued while global growth is expanding more solidly,” says Lee Hardman, a currency analyst at MUFG. “We would be more concerned if rising inflation expectations were backed up by more hard evidence of higher inflation which would pose greater upside risks to global yields and thereby a greater threat to financial market stability.”