Stocks in the US are back at record highs.
Less than three weeks after the Brexit vote rocked markets and we heard proclamations of another “Lehman moment” — and then arguments that Lehman wasn’t a moment, arguments that this isn’t at all like Lehman, and so on — headline stock indexes in the US would have you believe that things are fine.
But underneath the surface appears a familiar trading pattern — a sharp dislocation in markets on the downside followed by a violent rally back to recent highs — and one that makes the headline recovery look less reassuring.
Over the last two years, we’ve now seen numerous episodes of abrupt declines of over 5% in the S&P 500 followed by quick snapbacks.
The central-bank “sponsored” strategy of buying any and all dips in the market — be it a backup in bond yields or a drop in the stock market — has been a profitable trade since the financial crisis, and old habits are hard to break. Traders are still very much conditioned to buy after initial signs of trouble.
These wild swings — the stuff of crisis-era markets — are now something that has become very much ingrained in the psychology of markets.
We’ve heard for more than the last year now of concerns about liquidity, specifically bond-market liquidity. But it’s obvious that bond markets are not the only places where liquidity becomes scarce at precisely the moment it is needed, leading to “air pockets” where assets gap down in price as a minnow-like effect creates a hole in the market.
Now you see the quote, now you don’t.
In a note to clients on Tuesday, Neil Dutta at Renaissance Macro looked into the still high correlations between and across asset classes that you’d traditionally expect to be uncorrelated.
That is, assets that once moved in different directions at the same time are now moving in the same direction at the same time.
“The global financial crisis started almost 10-years ago and while that may be a distant memory for some it left a lasting imprint on the global economy.
“For financial markets, the behaviour of asset prices continues to exhibit crisis rather than pre-crisis characteristics. Most notably are the persistently high cross asset correlations… The one implication we would like to point is that because of the high correlations, market volatility in one country is more likely to be transferred to another and more quickly.”
We hear often about how global markets are more connected today than they have ever been before. Rising correlations make this much clear.
But more interconnected markets don’t mean more liquid markets, or markets more ready to handle the wild swings we’ve become accustomed to seeing.
Mohamed El-Erian, in his seminal book, “The Only Game in Town,” about the current conditions plaguing markets and central bankers in a post-crisis world, writes of the “liquidity delusion” that prevails:
“Judging from the portfolio risks accumulated in recent years, including the large amount of dollars at risk, the low compensation paid to investors for assuming such risk, and the extent to which many crowded portfolio positions can move together — investors appear to strongly believe that the markets would provide ample liquidity for them to re-position their portfolios should they ever need to.
“That is to say, when the time comes to sell of buy securities, there will be someone on the other side willing to transact in size and at a reasonable cost… Interestingly, this expectation of ample liquidity runs counter to what has actually transpired when consensus view have changed and investors have sought to re-position their portfolios accordingly.”
El-Erian draws from Howard Marks’ memo that was published in March 2015, which is now clearly the touchstone moment for thinking what liquidity is and is not and why, quite simply, we are in plainly illiquid markets now.
Marks defines liquidity as the ability to trade in and out of positions without those trade affecting the price at which those trades can be executed.
Looking at our most recent example of an air pocket, there was clearly an inability for traders wanting to move out S&P 500 futures overnight on June 24 to do so without moving the market in size.
The same goes for traders of almost all assets that night, notably the pound, which got crushed not just against the dollar (falling 9%), but more notably against the Japanese yen (falling 14%).
And while the Brexit vote is a seminal moment in post-Cold War geopolitics, its implications for financial markets — then and now — remain unclear. The market reactions, in turn, were not justified by anything other than fear.
Fear often drives markets, and when we were last at all-time highs Yale professor Robert Shiller argued that an increase in stock and home prices were likely, at least in part, driven by our anxiety about the future.
But fear driving major currency and equity markets up and down 10% in just a few days is not behaviour that persists in normal markets. This is the kind of behaviour we saw during the financial crisis and something that still drives markets today.
There’s no going back
Pricing information flows freely and quickly across markets and networks. Put simply, everyone is in everyone else’s business.
And while the Brexit vote and the popular rhetoric of candidates like Donald Trump and Bernie Sanders make clear that there exists a desire to turn back the tide of increasing globalization that has dominated the last generation of economic development, there is no going back for financial markets.
The rise of cheap exchange-traded funds that open up all kinds of once esoteric market exposures to the masses is but one example of how markets have gotten flatter.
And while concerns about a market full of passively managed money turning us all into beta-chasing socialists are somewhat overblown, it is clear that we are in a situation where any investor can cheaply and quickly get what they want … but no one knows if they can really get out when they want.
Stocks are at all-time highs. This will be the headline. This is a true statement. It is not something to dismiss.
But what is happening under the surface and the linkages we’re seeing revealed between and across markets is where the action is. And where it will be from now on.