The Wall Street Journal had a very good article detailing one of the root causes of the February decline. A classic ‘tail-wagging-the dog’ story about derivatives and how they can impact other markets that are seemingly unrelated. While the outlook for global equities informs the level of the VIX, we have just seen an incident where forced trades of VIX futures impacted futures prices of equity markets. Its as though the cost of insuring against market declines went up so much that it caused the event it was insuring against.
Even with that being known, the impact to market sentiment has been dramatic. Most sentiment indices went from extremely optimistic to extreme fear in a matter of days. This change in attitude by market participants may have a lasting impact. A rapid decline like we saw in February will reduce optimism and confidence (which underpin a bull market rise), and increase fear and pessimism, which are the hallmarks of a bear market. Short term indicators turned very negative and now are more neutral, but longer-term sentiment indicators will take a longer decline to move negative.
Often the end of a bull market is marked by a rise in volatility, with equity prices falling 5-10%, then climbing back up only to get knocked down again, until finally prices cease climbing back up. This can take several weeks or months. We can see this in the market tops in 2000 and 2007. This may be occurring now. Many of the market commentary I follows the approximate theme of ‘markets likely to test the 200-day moving average’. This is the level the February decline found support. This would be about 7% below current prices, and have the makings of a completed correction, finding support once and then retesting.
Since the market highs in late January the major stock indices fell 12%, then gained 6-10% depending on the index. Since that bottom and top; markets moved down about 4.5%, then again up into yesterday (3/13/2018) gaining 4% to 7%. Tech shares and small caps have outperformed large cap along the way, rising more, but falling the same during this series. Recognizing the size of these moves and the time frame can help manage one’s risk and exposure without getting overly concerned with a 2-3% move in prices. But if one is not aware of how the 3% moves are part of the larger moves, one might wait through a series of small declines and find themselves uncomfortable just as a decline is ending—contemplating selling at lower prices as opposed to looking to buy at lower prices. Hedging is a process to dampen the markets impact on a portfolio in the short term while looking for larger longer-term trend turning points. The high in January and current decline and bounce are likely a turning point over the longer term and in the near term provide investors with parameters to determine if the bull trend is still intact.