One hedge fund laid out why the market feels so dangerous right now

Knife tongue dangerousMartin Mejia/AP ImagesStreet artist Ruben Acosta balances a knife on his tongue as he performs for tips in Lima, Peru, Monday, Jan. 26, 2015

It seems that the stock market has either been doing nothing or going wild in 2016.

For the first two months of the year, a massive global sell-off drove volatility through the roof before Brexit rocked markets in June.

Other than that, stocks have been quiet, almost too quiet, setting records for their lack of movement in either direction.

According to Highbridge Capital Management, a $25 billion hedge fund, these long quiet periods followed by extreme jumps in volatility is going to continue for the foreseeable future.

“2016 is showing us that the ‘new normal’ market environment is fragile, characterised by extended periods of extreme calmness followed by bouts of extreme volatility,” said the third quarter investor letter from Highbridge.

According to Highbridge there are two reasons for the “new normal” in the market.

One is simply that macroeconomic events are causing sell-offs every so often. The January sell-off was triggered by the combination of collapsing oil prices, China fears, and a recent Fed rate hike, while Brexit lead to the selling in June.

The second — and arguably more important — issue, according to Highbridge, is the very structure of the market itself. From the letter (emphasis ours):

“Market structure, which has rapidly evolved in recent years, may be partly responsible. Massive flows in and out of passive mutual funds, ETFs, risk premia funds and the like are increasingly driving movements in security prices, weakening the link between prices and fundamentals and increasing short-term volatility. According to Citi, in 2015 passive funds (defined as index mutual funds and index ETFs) represented 31 cents out of every dollar of trading in U.S. equities, up almost 2x since 2005. Since 2014 through the end of Q2, passive funds globally have seen $1 trillion in net inflows. Liquidity has also declined in recent years, further exacerbating swings in volatility.”

Put another way, fewer actively traded shares are leading to bigger gaps when uncertainty strikes and less everyday churn on average days, making things more boring.

Now, Highbridge is an active manager, so some of the complaint may simply be griping from an industry participant that has seen a shift away from their type of fund to passive funds. This doesn’t necessarily mean, however, that the idea isn’t in part true.

So what is a fund like Highbridge to do?

Well, the fund determined that the only way to truly succeed in the market is to always be ready when the crazy times roll around.

“In order to navigate markets, it has become more important than ever to be nimble and liquid, and it is increasingly challenging to manage strategies that require significant leverage to capture a small edge,” said the letter.

Watch out.

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