Understanding why financial markets are caught in the grip of the kind of volatility that has seen moves of more than 8 percent in two days may have more to do with trading the trend than a radical shift in the economic growth outlook. And that might mean that selling pressure lingers longer than usual as the dust settles on a bruising 48-hour sell-off.
Several analysts and investors have flagged the part played by trend-following funds, known as "commodity trading advisors" (CTAs), in exacerbating last week's rush for the exit. Rather than look at fundamental analysis of a particular stock, these trading strategies are technical and designed to react to specific price moves and market direction. For every 10 percent drop in equity indexes, J.P.Morgan estimated CTAs and others might need to then cut some $100 billion in equities.
"In the current environment, these investors are selling equities and will negatively impact the market over the coming days and weeks," J.P.Morgan strategists, who say CTAs have about $350 billion of assets under management, wrote in a client note. Markets moving in lockstep also makes things harder for stock-pickers looking to exploit divergent performances. August saw record levels of so-called market correlation within European equities, according to S&P Dow Jones Indices research.
"Correlations have been far higher than average... There has been indiscriminate selling across all sectors," said James Helliwell, director at a trading academy set up by former Goldman Sachs banker and hedge-fund manager Lex van Dam. "It has been a clear concern for most market participants." Plenty of brokers and traders have pointed out the silver lining to this trend trading in recent days, namely buying opportunities in unfairly punished cash-rich, big-name stocks.
Morgan Stanley put out research on Tuesday saying European equities were set for double-digit growth rates over the next twelve months, even after their earnings growth expectations had been reset to zero. However, the wholesale trades muddy the exact timing for investors on when to "buy the dip", partly because of the crowded nature of a lot of popular trades. The sell-off saw cutbacks in exposure but no real change to overall core holdings, traders said.
"There is still a case for euro zone equities and there is still value... We haven't seen massive outflows," BNP Paribas equity and derivatives strategist Ankit Gheedia said. "People are still waiting for clarity, though... A slowdown in China, now it's happening, is not a surprise. The significance of the market move and the effect it's had ... is." So while bets are certainly mounting for a new round of dovish central-bank support, investors are waiting for the trigger rather than pulling it early - especially if the shake-out has more to go.
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