Wall Street Fears Market Fragility in $23 Trillion Stock Frenzy


It’s not your imagination: Stock markets are lurching from meltdown to melt-up like never before.

After one of the swiftest corrections in history, the S&P 500 is now back within a spitting distance of pre-crisis levels. Likewise the February 2018 crash was followed by a swift resurgence, while the late December swoon that year was a mere memory the following April.

The danger now is that investors are stampeding into yet another cross-asset rally ripe for a violent reversal. This tendency for markets to sway suddenly between extremes highs and lows is increasingly a feature of modern trading.

Bank of America Corp. strategists have a term for this: Fragility. They reckon high-fragility events are kicking off five times more frequently since the global financial crisis compared to the decades from 1928 onwards.

“In a world where alpha is hard to come by, you have to go with the trend,” said Benjamin Bowler, Bank of America Corp.’s chief global equity derivatives strategist, in an interview. “Because of that low conviction, when the trade turns, everyone wants to get out at the same time because they were only there when the trade was working.”

Societe Generale SA strategists calculate the frequency of freakish moves in the S&P 500, a measure known as kurtosis, is nearly double its three-year average after reaching a two-decade high this year.

Blame investor herding, monetary stimulus, weak liquidity, or excessive leverage. Whatever the culprits, it’s no easy problem to hedge, with market shocks becoming ever-more unpredictable and the intermittent rallies painful to miss.

Wall Street Fears Market Fragility in $23 Trillion Stock Frenzy

Bowler’s recommending to clients a ‘W’ trade that buys out-of-the-money S&P options which pay off sharply when there are extreme moves both up and down, while collecting a steady premium from selling contracts that are nearer to in-the-money. SocGen has a strategy that follows intraday stock trends, built for fast-moving markets prone to outsized price moves.

“If all the central banks continue to artificially suppress volatility and support markets and have a heavy hand, I think this environment is going to continue,” Bowler said.

Herd mentality is on full show of late in the nearly $23 trillion global stock rebound. The Nasdaq 100 has been flirting with overbought levels while corporate bond prices are recovering to their pre-pandemic highs.

Yet as coronavirus cases climb across the U.S. and economic data signal continued weakness, the threat of extreme price moves is clear. A metric that tracks just how volatile implied stock swings are, the volatility of volatility, is still one quarter higher than the decade average.

The post-crisis era has already seen five market blow-ups as measured by kurtosis, which calculates how often extreme moves are occurring relative to normal, or so-called fat tails. That compares with typically just one in a decade between the 1920s and 2008, according to Bowler’s calculations. In credit and equities, the metric reached at least three times its previous peaks this year in the pandemic crash.

A recent example: On June 11, the S&P 500 plunged 5.9% amid signs of a second wave of the coronavirus in America. In terms of how sharp the move was relative to what volatility trends were projecting, that was the 25th biggest shock out of roughly 23,000 trading days since the 1920s, according to Bowler’s analysis.

Wall Street Fears Market Fragility in $23 Trillion Stock Frenzy

One problem is that high-frequency traders have filled the void left by investment banks after regulations made it harder for the latter to facilitate trading. As a result, liquidity -- or the ability to find buyers and sellers at a tight spread -- tends to vanish quickly during sell-offs.

“Liquidity conditions haven’t quite come back to normal, especially in equities,” said Sandrine Ungari, head of cross-asset quantitative research at SocGen. “Any spike in risk aversion is most probably going to trigger a lot of volatility.”

Hysterical markets are posing particular challenges for systematic strategies. Ones that target volatility have struggled to cut positioning fast enough during drawdowns and then catch up with the rally. Trend followers with a medium-term view may also find fewer winning trades in cross-asset trading that zigzags rapidly.

At Mellon Investment, Roberto Croce says it’s never been more important to adjust positions based on fast-moving measures of risk -- like three-day realized variance, a measure of stock deviations relative to the mean -- even if it means selling into a down market.

“Risk seems pretty low and then it’s not -- it seems to jump a lot faster than it used to,” said the manager who oversees risk-parity and managed-futures funds.

©2020 Bloomberg L.P.

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