Three charts that hint market rout isn’t over
Despite recent gains, traders remain skittish following Monday's market meltdown and liquidity rout. Unprecedented moves early this week sent the Dow (^DJI) tumbling over 1,000 points intraday and volatility (^VIX) jumping a record 90% to a four year high. While the sell-off in China received much of the blame for the severe U.S. market drop, traders and economists say foreign markets are only one part of the calculus.
High-frequency trading undoubtedly played a significant role, says Stephen Guilfoyle, Managing Director of NYSE Floor Operations for Deep Value Inc. “The old aim of best execution has been replaced by the aim of quickest execution, [hence] the art of price discovery has suffered terribly in recent years,” he says.
Others take a more macroscopic view. In an op-ed piece, Harvard professor Martin Feldstein says the collapse was “the inevitable result of the Federal Reserve’s policies, namely quantitative easing that produced abnormally low interest rates.”
Regardless of the cause, history reveals how events similar to Monday's have unfolded in this six-year bull market. Two extreme examples of sudden, violent downturns stand out, and they might foretell what the markets have in store over the next six months.
During the flash crash of May 6, 2010, the Dow also tumbled over 1,000 points intraday, as volatility spiked 63%, eventually reaching 48.2. Shortly thereafter, the S&P 500 (^GSPC) made an interim low, and it took another month for the market to forge a bottom. Finally, more than six months after the market began its initial decline, the S&P 500 broke out to new highs.
Another sudden drop occurred in the summer of 2011, when troubles in the European periphery spooked the markets. But the true carnage would manifest when Standard & Poor’s unexpectedly downgraded U.S. debt, unleashing another avalanche of selling on a Monday with a concomitant spike in volatility. The subsequent weeks and months developed similarly to the flash crash scenario.
From top to bottom the S&P 500 fell 17% in the summer of 2010 and 20% in the summer of 2011. The current decline registers at 12% so far.
Just over a month has passed since the S&P 500 began faltering in late July this year. There are signs that suggest the markets could be gearing up for significant further declines, says Mark Newton, Chief Market Trader at Greywolf Execution Partners Inc. However, he says, a continued falloff isn’t necessarily imminent.
“Just look at the time we’ve gone without a 10% or 20% correction,” Newton says. “Historically, these rallies, when they do turn around, they tend to be pretty ugly, erasing anywhere from 25% to 40% of what you’ve done. That would mean a much bigger decline.”
After the sharp drops in 2010 and 2011, volatility continued to surge as order books thinned at the slightest headline risk. Eventually, traders waded back into the markets as liquidity slowly returned. It may take many more months before investors fully regain confidence, Guilfoyle cautions, “I think that as long as there are so many uncertainties, it will be difficult to price this market.”
