It’s not all about Trump this time…
Investors are always guilty of building cozy little narratives to explain every single market move. So when stocks finally fell out of bed yesterday, we blamed the drop entirely on the turmoil surrounding the Trump administration.
Why else would the Dow have dropped almost 375 points?
I’m not buying it. I won’t deny that political concerns are weighing heavily on the minds of investors right now. Not a day goes by without some form of Trump-related scandal coming to light.
But there’s more to the story than James Comey, Michael Flynn, Robert Mueller, or the Russians.
Instead of picking apart the political headlines, we need to turn to the market for answers.
Let’s start with the VIX.
The market’s unofficial fear gauge ripped higher yesterday by more than 45%. It was its biggest move since September.
But we must put this VIX spike into the proper context. Remember, investors have enjoyed record low volatility so far in 2017. Just last month, the VIX suffered its worst drop since 2011. Market action had been downright boring. Stocks hadn’t seen a meaningful drop in months. And any trader who bet big on the market falling apart was torn to shreds every single week.
That’s a recipe for complacency, which brings us to the perfect storm scenario for this week’s giant volatility spike…
Keep in mind, VIX options expired yesterday. Also note the “short volatility” crowd has enjoyed a flawless run for months.
“Think about a trader who has short exposure coming into expiration. They’re pretty confident they can let their options hang out into expiration,” Investing with Options head trader Steven Place explains. “But then something shifts. On Tuesday, the market comes back into support. Being a smart trader, you pick up some hedges in the VIX futures market, or some other instrument. Well, when you do that, the market maker has to take the other side, and eventually you get this cascade of short volatility exposure that starts to unwind.”
What we saw yesterday was a case of the tail wagging the dog, Steven explains. The volatility squeeze spilled over into a full-blown market selloff.
A quiet market lulled investors to sleep. Now we’re seeing psychotic traders setting their hair on fire over a 2% market drop that’s taken the S&P 500 back to levels we haven’t seen since… April 20th.
Once we start putting yesterday’s move into perspective, it becomes clear that we’re not dealing with the end of the world – or even the end of the bull market.
My friend Michael Batnick over at Ritholtz Wealth Management reminds us that yesterday’s drop was only the second day so far this year where the S&P has lost at least 1%. Turn back the clock to this date in 2016 and the S&P 500 has already fallen 1% a whopping 17 times on the year…
Batnick also notes the S&P 500 hasn’t posted a 5% pullback since July 2016. Face facts – the market’s long overdue for some meaningful downside action.
Of course, the financial media will continue to play politics while investors throw a temper tantrum over a normal, run-of-the-mill selloff.
The noise is only going to get louder from here. Ignoring the circus is the only way to survive…