Saturday, August 8

Something ‘dangerous’ is happening beneath the surface of the market selloff

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No asset class appears to be safe amid the current global market rout. And while it goes without saying that people are losing money, the phenomenon may underscore something far more ominous.

“For the last few weeks, while we’ve had this volatility, you’ve had stocks zig while bonds zag. So every time stocks went up, bonds tailed off and vice-versa,” Academy Securities’ Peter Tchir said on Yahoo Finance’s The Final Round. “All of a sudden, that behavior changed a little bit into the close yesterday. And making it even more dangerous to me, you saw oil fall off into the close. Commodities were selling off. Even Bitcoin was selling off into the close.”

Typically when uncertainty spikes in financial markets, traders and investors will rotate out of risky assets like stocks and into ‘safe haven’ assets like bonds or perhaps gold. When this happens, risky asset prices go down and safer asset prices go up.

But when market participants are panicking, they begin to cash out of everything. And that can lead to even more panic.

In a note to his clients titled “Did Someone Hit the ‘Sell Everything’ Button?,” Tchir wrote that “While increases in volatility are concerning for market participants, changes in correlations, while more esoteric are far more dangerous. Changes in correlation can affect portfolio level volatility far more dramatically than a simple increase in volatility across asset classes (sounds wonky, but this is important).“

The U.S. services sector is at risk

While panic selling is often characterized by the indiscriminate dumping of assets with little regard to fundamentals (like the supply and demand for goods and services), Tchir notes that there may be something real to justify what’s happening in world markets as the spread of the coronavirus (COVID-19) affects consumer behavior.

“I’m really focused on the tourism angle,” Tchir said to Yahoo Finance. “China has become a huge consumer of tourism. The Chinese spend more money outside of China than any other country spends on foreign travel. I think that’s part of the reason we had very weak service data last week. And that service data, to me, has been really important.”

Tchir was pointing to last Friday’s IHS Markit Flash U.S. Composite PMI report, which suggested that U.S. services activity was at a 76-month low.

This is critical because services eclipses manufacturing in the U.S. economy.

“For the past few years, every time we get a hiccup we can argue, ‘Well, we’re not a manufacturing economy, we’re now a service economy,’” Tchir said. “If services go, that is very problematic. I think that’s going to get hit very quickly by this slowdown in foreign travel from other countries.”

Portfolio hedges are breaking down

The Dow Jones Industrial Average (^DJI) has fallen a whopping 2,400 points since last Wednesday.

For folks with diversified portfolios, the expectation is that some of the non-risky (e.g. non-equity) asset classes should provide some hedges.

That’s not happening. And that could make things worse.

“I think volatility has been elevated long enough that there is some selling pressure which is also changing correlations, causing more selling pressure,” Tchir wrote. “I expect portfolio volatility to increase as funds caught in the same trades create a vicious cycle of needing to sell everything, exactly when buyers of everything are being tentative.“

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