The Storm after the Calm—Assessing the Current Stock Market Swings
In a rude awakening, investors have been rattled out of their comfort and confidence over the last 10 days, facing unprecedented volatility in both the Dow and the S&P 500. In just five days, between February 5th and February 9th, the Dow dropped more than 1,000 points not just once, but twice, including the largest point drop ever during a single trading session. On Monday, February 5, the Dow dropped 1,597 points, losing more than six percent of its value, before rebounding to close down 1,175 points… almost 40 percent larger than the previous largest intraday drop. The dramatic ups and downs continued when the market opened on Tuesday, as the Dow took an immediate 567 point dive, but rallied to a 350 gain within a couple hours. As of Thursday, February 8, the index had lost more than 10% from its most recent high, officially signaling a correction.
Not surprisingly, analysts have put forth a number of potential explanations for the seesaws:
- The rise of the machine—According to many stock market watchers, an integral driving factor in the direction of the market is program trading. With program trading, human factors (such as emotion) are eliminated from the equations. Computer programs, with sophisticated algorithms, initiate buy and sell orders based a variety of market factors, including price, market volume and other variables. It’s estimated that, on a normal trading day, program trading accounts for at least half of the total trades executed. As the market becomes more volatile, the triggers for program trades will be pulled more quickly, so that in markets like last week, program trading can account for up to 90% of all trades. The New York Stock Exchange had enacted a rule, in the wake of the stock market decline in 1987, which would institute an automatic curb if the Dow moved more than 2% of its value in either direction, but that rule was revoked in 2007.
- Fears about inflation—Wall Street analysts have suggested that the decline in the market is tied to rising concerns that the U.S. economy is headed toward a period of inflation. A government wage increase report in early February added fuel to that fire, with higher than expected wage increases confirming for many investors that the American economy may be overheating. Analysts have anticipated that the Federal Reserve will bump up interest rates over the next 12 to 18 months, but fear that unexpected inflation may cause the Fed to take a more aggressive posture. If interest rates go up, businesses will face increased borrowing costs and will likely opt to limit expansion.
- Speculation on volatility—Many market observers, most notably Jim Cramer of CNBC, believe that a key contributor to the recent volatility is volatility itself. Some years back, the Chicago Board Options Exchange (CBOE) created a volatility index, which attempts to gauge the anticipated 30 day volatility in the market. Investors can trade in the volatility index, known by its ticker symbol, the VIX. There’s also an investment known as the Velocity Shares Daily Inverse VIX short term exchange-traded note, (the XIV), which is supposed to provide the exact opposite return that the VIX does. Cramer and others believe that much of the volatility in the market over the last couple weeks has been spurred by investors speculating on both the VIX and XIV.
- A stronger correction to a stronger market—There’s also substantial support for the perception that the dramatic ups and downs are an expected and natural occurrence in an overconfident market. Analysts point out that, historically, a correction occurs in the market about every 11-12 months. Until last week, there hadn’t been such a correction in about two years. In fact, since January, 2017, the Dow had experienced a 26% increase in value, more than three times the average annual rate of growth.
Analysts say investors had become overconfident, fueling a growth that inevitably could not sustain itself. Furthermore, in periods like the last two years, when there’s such long-term positive movement in the stock market, many individuals who wouldn’t normally participate put money in stocks for fear of missing out on a once-in-a-lifetime opportunity. Because of their inexperience in the market, these individuals tend to be more skittish and are the first ones to pull out during any sign of decline.
Most market professionals believe that there’s still significant volatility and a likely decline in the near future. Since the end of World War II, the average length of a market correction (according to MarketWatch), is a little over two months and the current drop has been less than two weeks. Here are some of the factors that may determine the depth of the correction and how long it will last:
- The U.S. economy—the American economy has been and continues to look strong, with low unemployment, healthy consumer spending and minimal inflation. The extent to which any of those indicators changes will have an impact on the market.
- Corporate fundamentals—Corporate earnings remain strong and many corporations will benefit from the recent tax overhaul.
- The impact of so-called “flash crashes,” often tied to computer trading
“In a rude awakening, investors have been rattled out of their comfort and confidence over the last 10 days, facing unprecedented volatility in both the Dow and the S&P 500. In just five days, between February 5th and February 9th, the Dow dropped more than 1,000 points not just once, but twice, including the largest point drop ever during a single trading session.”
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