Crazy Correlations Cause Contagion Selling – Will it Persist? Mike Larson | Monday, September 12, 2016 at 4:30 pm
Crazy correlations. That’s what was behind Friday’s contagion selling. And before I answer the next logical question – namely, is the selling squall over? – I want to share something with you.
I’ve included a chart of the “Credit Suisse Cross-Market Contagion Indicator.” A mouthful, for sure. But basically, the indicator is designed to show how linked (or unlinked) various assets are in terms of movement.
When currencies, stocks, bonds, and other asset classes are all basically trading together, the index rises. When they’re actually trading on their respective underlying fundamentals, the index falls.
The most fertile environment for stock market gains is when the index is falling and/or low. That’s because fundamental analysis yields richer rewards, and because you can gain some measure of safety by diversifying your investments. We saw that in the heart of the bull market in the mid-2010s.
But look at the chart below and you’ll see this index is now at its highest level since Credit Suisse rolled it out in 2008. That means assets of all shapes and sizes are basically moving on one single catalyst – central bank funny money.
Afternoon MAM chart
That means any minor suggestion that monetary policy might be dialed back can set off a financial hurricane. Or as one analyst said in the Wall Street Journal today:
“Nobody has been buying on fundamentals, but on technicals … And the dominant technical has been central banks being massive buyers of assets.”
The Financial Times also warned today that market risks are much larger now because hundreds of billions of dollars globally are invested in algorithmically driven, volatility-based trading strategies. When the markets behave like they did this summer, those strategies work just fine. But when you get simultaneous selling of both stocks and bonds, it wreaks havoc on them and can lead to an avalanche of sell orders.
So what’s the best course of action? Well, it’s only natural to see markets stabilize after a nearly 400-point rout in the Dow Industrials. That’s what happened earlier today right as markets tested key support around 18,000 on the Dow and 2,100 on the S&P 500 futures. The question is whether this is just a rest stop on the road to lower prices, or the place where big money investors will make a major stand.
“I refused to get sucked up in all the Wall Street hype.”
Personally, I’ve been in the cautious camp for a while now. I refused to get sucked up in all the Wall Street hype about the big “breakout” in July – and sure enough, we’re right back to those levels.
I’m inclined to use any bounces here to lighten up and see how things go. Or if you’re a more aggressive investor, you can take advantage of those bounces to add select put option or inverse ETF positions that are designed to rise as stocks fall. You can get my favorite picks in my All Weather Trader service.
I’ll wrap things up by referring to some recent comments from Allianz chief economic adviser and FT columnist Mohamed El-Erian. He used typical corporate-speak in this piece. But it was clear he wanted to get a very important point across when he wrote:
“The days of central banks delivering win-win-win outcomes to investors — that is, high returns, low volatility and profitable correlations — could well be coming to an end … Given also crowded portfolio positioning, this is a good time for investors to bring down market exposures.”
Translated into plain English: Dump some stocks, raise more cash, and batten down the hatches against further market squalls. Sounds about right to me!