A person skating
Investors might be skating on thin ice as Christmas approaches © Vladimir Smirnov/TASS

Investors have been blithely skating into the Christmas period, basking in another remarkable rally across financial markets. But the ice underneath may be thinner and brittler than many realise, as Friday’s violent sell-off showed.

The past decade has been characterised by unusually calm, strong and long stock market bounces that have occasionally been punctuated by brief but exceptionally ferocious nosedives. This is not a new observation. But there is rising acknowledgment of the phenomenon, mounting research into it and growing understanding of the drivers — even if no one seems to agree on the primary cause.

The latest exploration of this market regime came from US investment group Wellington this summer when it published a report titled “Why fragility is the new reality for the stock market”.

It makes for compelling reading for anyone feeling nervous over the fact that the global stock market has returned more than 14 per cent this year, and had gone six weeks without moving more than 1 per cent in either direction until fears over a new coronavirus variant triggered mayhem on Friday. In fact, the suddenness and severity of the turbulence is another case in point for the “fragile markets” hypothesis.

The central problem identified by Wellington is a mismatch between demand and supply of liquidity — essentially how much investors want to trade versus how easy it is to trade, which becomes particularly acute at times of market turmoil. Essentially, both the imperative to sell and the ability of markets to handle a flurry of sales has become more procyclical, leading to an increasingly painful mismatch whenever markets are in turmoil.

Chart showing US stock market trading conditions have weakened

When markets are calm, trading conditions are largely fine. But when the quiet shatters, many investment funds are either compelled by nervous risk managers or automatically by algorithmic rules to sell.

At the same time, market-making is now virtually exclusively a game for high-frequency trading funds. When volatility rises, HFTs guard themselves by swiftly widening the prices at which they will transact and ratcheting back the size of orders they are willing to handle.

“An imbalance has developed between the supply of and demand for liquidity, and as a result we’ve seen a significant increase in the potential for the public equity market to jump from a state of calm to one of chaos,” Wellington argued in the report.

“Consequently, we tend to distrust situations where stability has become the consensus, as we believe any change in the narrative is apt to bring surprisingly drastic changes in the equilibrium.”

This echoes work done by the likes of Corey Hoffstein at Newfound Research, Michael Green of Simplify Asset Management, Christopher Cole of Artemis Capital Management and Benjamin Bowler of Bank of America — even though they often emphasise different causes and aspects.

Green reckons that the rising tide of passive investing is severely exacerbating the market’s fragility. Cole has focused on the problems of using volatility as the dominant proxy for risk, and how embedding into the fabric of the entire investment industry might make sense for funds individually, but collectively makes the entire system more fragile.

Chart showing volatility-sensitive strategies are quick to ditch exposure

Hoffstein also highlights how central bank backstops have encouraged more risk-taking, but argues that it is the collective interaction of all these factors that can cause “cascades that send markets spiralling out of control”.

However, Bowler, global head of equity derivatives research at BofA, thinks that many of the more technical aspects mostly exacerbate a singular fundamental, underlying driver. “A lot of these other factors are icing on the cake,” he argues. “The cake itself is monetary policy.”

Chart showing that liquidity has become more procyclical

Bowler was one of the first to begin to dissect the phenomenon back in 2015. His view is that the alacrity of central bank intervention whenever markets swoon suppresses market volatility, leads to periods of rampant risk-taking and investor crowding which, in turn, then makes reversals rarer but disproportionately violent.

Yet knowing that central banks are always ready to act encourages investors to quickly buy the dips. “They’ve been conditioned like Pavlov’s dogs,” says Bowler.

Luckily, some investors are increasingly aware of the ice’s brittleness, and are adapting to the new environment. Cautiousness may be wise.

Bowler points out that if inflation continues to run hot, it may tie the hands of central banks in future market nosedives, short-circuiting the “buy-the-dip” mentality that has dominated the past decade.

“Inflation is the kryptonite for the low-volatility regime,” he warns.

Email: robin.wigglesworth@ft.com
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