Wall Street whiplash teaches traders how to cope with the fragility of modern markets

However, the summer crash will also go down in history as a particularly extreme example of a trend that has formed Modern Finance For years now, there have been increasingly frequent clashes that break out without warning.

Just as quickly as volatility erupted, it calmed down and the S&P 500 posted its biggest weekly gain since November. junk bonds Markets have posted a week of gains, and Treasury yields are stabilizing. In one particularly vivid example, the VIX index, Wall Street’s “fear gauge,” just broke two records: the fastest-ever rise of 25 points or more and the quickest recovery since the surge, according to UBS Group AG.

Reversals are a nightmare for anyone trying to attribute sensible explanations to market action. Was the trigger for the August plunge technical in nature or something more sinister, such as fears of a Federal Reserve policy failure and an impending crisis? I have a bustWhatever your opinion, feverish markets They periodically swing from euphoria to despair (and back again just as quickly) amidst an interconnected herd of leveraged people. Traders.

In fact, the increasing frequency of price spasms that quickly reverse has been an expanding wing of financial research since at least 2019, when Bank of America CorporationStrategists used the term “fragility” to describe events that have become five times more common than in the previous century. These include the fear of China’s devaluation in 2015, the Volmageddon trauma of 2018 and the COVID-19 crash.

“We would characterize the extreme market ups and downs “The shock of the past two weeks is the latest illustration of how markets have become inherently more fragile over the past 15 years,” said Nitin Saksena, head of U.S. equity derivatives research at BofA. “The speed with which the shock dissipated only reinforces our conviction, as rapid mean reversion is a hallmark of fragility shocks due to their technical nature. A more fundamental shock would have more staying power.”

In the past, blowouts included crowded trading and risky liquidity, both of which were evident in 2024, when a handful of AI-powered superstocks dominated index returns and left large swaths of the equity universe largely unsupported. The fragility became apparent when rapid unwinding of popular positions, which also included the yen carry trade, quickly spread across borders and morphed into market-wide disruptions.

The fact that such disparate assets were caught up in the tumult reinforces Saksena’s view that something in the very nature of the markets contributed to it. Bitcoin, the Swiss franc, investment-grade credit, copper and Japan’s Nikkei 225 all took hits, he notes, a lesson in “how pervasive fragility is in markets and how dysfunctional they can become in times of stress due to extreme imbalances between supply and demand.”

Bloomberg

A number of systematic funds sharply reduced their exposure to equities last week, and quantitative analysts who look for market trades were crowded out. Some estimatesLast Wednesday, three-quarters of the world’s carry trade was liquidated, for corporate clients and hedge funds alone. come running back Days later.

“We had a unique set of circumstances where a combination of positioning, risk pricing, level of volatility and market liquidity aligned in such a way that we challenged the things that had worked all year,” said Ashish Shah, chief investment officer of public equity at Goldman Sachs Asset Management. “And we really knocked down the positioning around those themes.”

This week saw the biggest concerted rally of 2024, with stocks, bonds and credit all rising in unison, according to data compiled by Bloomberg that tracks popular ETFs. The S&P 500 posted its best weekly gain of the year of 3.9%, snapping a four-week losing streak. The world’s largest Treasury exchange-traded fund rose about 1% as junk and investment-grade bonds made similar gains. Gold rose to $2,500 for the first time. The VIX fell below 15 after having risen above 65 at the height of the maelstrom.

Bloomberg

A raft of recent data prompted traders to recalibrate their Fed bets after reassuring signs on inflation. The producer price index, for example, rose less than expected earlier in the week. Swap traders are still pricing in nearly a percentage point of Fed easing in 2024, with the market bracing for a first taper in September. Attention is turning to the Jackson Hole symposium for some clue as to how Chairman Jerome Powell views the economy.

“We’ve gone from focusing solely on the Fed, rates and inflation to now focusing on earnings, economic slowdown and volatility,” Katerina Simonetti, a senior vice president at Morgan Stanley Wealth Management, said on Bloomberg TV. “It’s very confusing for investors, who sometimes tend to have a bit of a short-term memory.”

As the bond market continues to issue warnings of economic weakness, all 11 major equity sectors staged a concerted rally this week. With the Federal Reserve set to cut interest rates in a still-expanding economy, investors are once again worried about missing out on a recovery in riskier sectors and have been unwinding hedges they bought just weeks ago.

With sentiment potentially returning to euphoric levels, there is a greater likelihood of another disorderly market event. Framed this way, a group of investment professionals (particularly those who offer portfolio insurance known as tail risk hedging) argue that markets are increasingly fragile. Thanks to investor concentration, questionable liquidity, and the rise of volatility-sensitive investors who buy and sell based on technical, rather than economic, factors.

“We are in a zone where we are constantly making new highs, similar to how we have done at any other time in the market,” said Josh Kutin, head of asset allocation for North America at Columbia Threadneedle Investments. “That makes the market more fragile. It creates an atmosphere where people get spooked more easily.”