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In a scary market, what exactly do investors fear?

Michael Santoli
Michael Santoli

It would be easier to come to terms with the fear coursing through financial markets if it were clearer to see exactly what investors are so afraid of.

When markets start whipping around faster than the observable fundamentals, as they’ve done since late July, the always-dicey exercise of boiling the action down to a cause-and-effect story is even less useful.

It’s impossible to neatly explain Wednesday’s 444-point intraday swing in the Dow (^DJI) except as the twitchy reactions of traders to the recent wildness of the market itself, as it noisily knocks around tenuously above recent lows and near levels first reached 15 months ago.

Still, when volatility spikes as it has and the long-term stock-market trend threatens to give way, it’s usually because of a complex clustering of fears. Here are a few at play now:

-China, obviously. But what, exactly, about China’s situation is so scary? Hard economic landing exacerbating emerging-markets downturns, naturally. Capricious government moves to “manage” currency and stock prices? For sure.

All of it is occurring in a place with mistrusted data, where the market signals are staticky. It matters here mostly as a gauge of the tough adjustment the world is undergoing to less-generous credit conditions, and as a possible source of a “financial accident” among big, leveraged investors.

It’s easy to see this being placed in the “manageable headwind” category should our markets settle down in coming weeks. If they don’t it’ll be an abiding “cover story” for the anxiety.

-The Federal Reserve’s close call is an obvious overhang on the market psychology that helps push around trillions in bond-market money.

Yes, the first onset of a rate-boosting cycle in 11 years was going to cause some free-floating worry, no matter what. But in this case, the specific concern seems to be that a rate hike next week with financial conditions disordered and the market’s own forecast still showing a hike to be a long shot would imply a rigid, dogmatic stance by Fed Chair Janet Yellen simply that "It's time."

But one layer down, it’s worth asking whether the markets are fixated on the uneasy thought that the hike will come too late, rather than too soon. This doesn’t mean it would’ve been better for the Fed to have begun months or years ago.

But that the Fed had to wait until the corporate-profit and asset-appreciation cycle got so far along that the system is less equipped to absorb slightly higher frictional costs from a rate boost.

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Investment advisor Richard Bernstein, a veteran market strategist and portfolio manager of Richard Bernstein Equity Strategy Fund (ERBAX) for Eaton Vance, has been correctly bullish on US stocks and negative on emerging markets for years now. Yet he sees a potential Fed rate-hiking cycle coinciding with a decline in corporate earnings to be an unusual blend, and a tough one for markets to accept.

Could this be why the markets seem to prefer dovish noises from Fed officials at the moment, even if we all celebrate the economic conditions that would merit a rate hike?

Of course, we might be front-loading the pain from any Fed move, and could rally in relief no matter next week’s call.

-The market’s own mechanics are another broad source of fear. There have been seven daily moves in the S&P 500 (^GSPC) of more than 2% in the past three weeks. The CBOE Volatility Index (^VIX) has been ornery, refusing to ebb below the mid-20s, which indicates elevated market stress and aggressive hedging.

Various leveraged hedge-fund strategies have suddenly been discovered by the media and the worrywart industry, for the purposes of flashing alarm that they might wreak havoc.

Panning to a broad landscape shot, stocks have pulled back more than 10% after a 220% advance. At best, valuations and investor expectations are being reset helpfully. There’s no recession in sight for the US, which usually means no prolonged bear market.

We’re seeing all the sentiment and trading action one would hope to see for this to be a simple stinging correction. Stocks have pretty much “caught down” to the weakness in other areas like junk bonds.

But the longer we go in this stormy pattern without reasserting the upward trend, the more investors will be taken with that particularly daunting fear: That this unfriendly market “knows” something that we haven’t even thought to be afraid of yet.

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