Recalling my December piece, I discussed the fact that record low unemployment in the US has to result in either increased inflation (through wage pressure) or a complete redefinition of economic theory. Happily the market finally caught on and we don’t need to re-write the text books. On Friday the US Labor Department released their monthly jobs report wherein 200,000 new jobs were added with wage growth of 2.9%, the largest wage growth number since 2009. This sparked a sell-off in global equity markets leading to a 7% correction in the S&P 500 (8.5% in the DJIA). This was a much stronger reaction than the numbers merited and, admittedly, I was left scratching my head – why the overreaction? Did I miss some news? It turns out that I did not – We know that markets can behave like a school of fish, this seems to have been the case this time however, as we discuss below the reaction was magnified by fear… and algorithmic trading.
As ever there are a host of expert explanations for what happened after the event and there are plenty who say the worst is yet to come. Our own view is that investors shouldn’t panic just yet. Here’s why:
1. There was no fundamental trigger for the sell-off: It’s true that we are at an unprecedented economic crossroads with low unemployment and no sign of inflation and that can’t go on forever. The US unemployment data that came out on Friday was strong but it didn’t justify the market reaction. There is no structural change in the underlying economic story and the Fed is still likely to raise interest rates in an orderly manner.
2. Humans started it but computers compounded the problem: Fear and greed drive markets. The former certainly contributed to the sell-off however it looks like algorithmic trading – trading on mass across markets based on computer models – caused a lot of the anxiety in Monday’s session. Quite simply as markets fell and computers responded the algos couldn’t get out of their own way quickly enough driving markets lower.
3. The smart money sat on the sidelines: Passive volumes were disproportionately high at 40% compared to the daily average 25%. That tells you that retail positions were being established because retail tends to be skewed to passive. Retail investors do not have the tools at hand that professional traders have and as a result retail money tends to join the party quite late – buying the highs and selling the lows. The smart money – which tends to be long-term and active – sat on the sidelines.
4. A correction was needed: Markets have had a strong run and valuations in some pockets were looking stretched. History shows that short-term corrections are common and usually healthy in a bull market. I expect markets to be back to the January 26 highs before quarter end.
5. Look at it as a buying opportunity: Nothing has changed economically and corporate earnings continue to be healthy. As active investors we are reassessing and reallocating positions in our portfolios. Reduced valuations create opportunities to buy into sectors and companies that we like at valuations that are attractive.
One thing is for sure, you can’t time the market. If you had stayed in the market, or bought in the dip, during the Global Financial Crisis, Black Monday or even the Great Depression you would have done well over time. Underlying economic fundamentals are sound, tax cuts are on the way in the US and we have every expectation that central banks will raise interest rates in a considered and orderly fashion. Provided there are no unforeseen economic or geopolitical events we think investors have time on their side.
The writer is a partner at Crossbridge Capital.