Stock Market Fragility

The first time I heard the term “V-bottom” was in 2013.

A V-bottom is when stocks go straight down and come straight back up as if the fall was just a figment of our imagination. The idea that stocks could do this cemented itself in the fall of 2014, during the ebola virus scare.

The S&P 500 fell 7.5% in 19 sessions. It took just 11 days to erase those losses.

Stocks have always been volatile.

There were bear markets before zero-fee trading.

There were bear markets before ETFs.

There were bear markets before discount brokers.

There were bear markets before mutual funds.

Stocks have always been volatile because people have always been volatile. Prices are nothing more than a reflection of fear and greed, punctuated by periods of complacency.

We can see our own behavior through this lens in the chart below.

And while people have always been people, there is a big difference between how quickly we used to express our fear and greed versus how quickly we can express it today. And this is undoubtedly having an impact on the market.

Wellington Management is out with a great paper that shows how computers have augmented price movement. One of the examples they use shows lower liquidity when the VIX spikes. These liquidity providers are like the bankers who lend you their umbrella when the sun is shining, but want it back the minute it begins to rain.

I don’t see this reversing itself. Neither does Wellington. They said:

Given the fragile liquidity equilibrium, we expect the market to be prone to moving dramatically from low volatility to high volatility, with the potential for that volatility to then de-escalate quickly once systematic strategies have reduced equity exposure.

It’s tempting to try and come up with a response to this, but I don’t think a faster-moving market means you should do more. In fact, you should probably do less.

Josh and I spoke about this and much more, maybe too much more (sorry for the length), on this week’s The Compound and Friends with the hilarious and wicked smart Dan McMurtrie.