Fundamental Technical What Just Happened to the Stock Market

Fundamental Technical What Just Happened to the Stock Market Between January 26 and February 9, the Dow lost mora than 2,400 points, a 9 percent decline. This rapidfall in a short period of time has taken many of us back down memory lane to the financial crisis of 2008. Are we headed to a new crisis? A recession?When the stock market starts spiraling downward for more than a couple of days, we understand there is something more to the story than a mere flash crashor correction. What is actually going on behind the scenes, however, is not easy to uncover.Financial markets are complex. They are affected by many forces macro events, politics, fundamental information and news, technical movements of the market, market structure and instruments, spill-over effect from global markets, andso on.How can one decipher the main causes of a decline amid the noise?Could all factors be equally responsible?This most recent fall began with news on inflation and futur e interest rate hikes. This is good news. Inflation has been one of the Feds carefully watched benchmarks for economic recovery since the financial crisis. If the Fed is on the trajectory to increase interest rates, then the Fed is confident that the economy is strong enough to sustain the increase.This news welches followed by more economic news which supported the Feds outlook Jobless claims were down, productivity was up, unemployment was low, and wages were increasing.But havent we been expecting that inflation would rise, and so would interest rates? Why the surprise?As much as we have expected these things to happen sooner or later, no one was sure about the exact timing. Its not the news about inflation and rate hikes that spooked the market. The implications of these indicators for the economy are what caused uncertainty among traders.One of inflations implications is that the real value of an asset, such as a company, is less (as the purchasing power decreases), which may b e interpreted as investors looking for a higher real rate of return.Interest rate hikes may have an effect on the value of companies with high levels of debt on their balance sheets (e.g., Netflix). Such companies would need to pay higher interest on their debts, which would increase their interest costs, resulting in lower profits.The macro indicators of inflation and interest rates do have tangible implications for the economy, which we shouldkeep in mind and examine carefully in general and on a case-by-case fundament per company as events unfold in the coming months.But thats not the end of the story.Unfortunately, the uncertainty among traders triggered machine algorithms that amplified the spiral downward. The majority of trades today are done by algorithms. Since these algorithms are triggered by certain signals, even a small decline could set the market to a sell-off.The domino effect did not stop there. Market sell-offs tend to increase market volatility. another indicato r of market uncertainty. This in turn caused the volatility index (i.e., VIX) to spikemore than 200 percent. This is a normal reaction. When markets are down, volatility goes up. Therefore, the VIX spiking was not a surprise. The reactions of the instruments based on the VIX, however,were surprising.It seems Wall Street is not lacking in creativity when it comes to constructing trading vehicles that have the potential to blow up when things go haywire.What is the problem with these instruments? Lets take for example VelocityShares Daily Inverse VIX Short-Term ETN (XIV). Market volatility has been dormant for many years. Since the financial crisis, we have not experienced any major volatility spikes except for the summer of 2015 or early 2016, which subsided quite quickly. Wall Street professionals managed to find ways to make extra money out of this low VIX situation by betting against it, and the XIV is one example of that. Inverse VIX means that when the VIX is low (i.e., volatili ty is low), the instrument is going up (i.e., making money). Hence, as long as volatilitywasdormant, whoever held this instrument made money.One volatility spike, however, and these instruments can go almost to zero. Thats exactly what has happened to XIV it has declined bymore than 96 percent in a couple of days.Money managers who have invested in these instruments had to sell other assets (i.e., stocks) in buchen to cover for these losses, which created another domino effect. How much are money managers invested in these VIX instruments? We dont know. So, the sell-off could continue for a bit longer. (This type of instrument would be on our watch list as a barometerfor understanding the full extent of the sell-off.)Lets recap the trail of eventsThe macro indicators will take several months to a year to unfold. The technical indicators, however, are usually short-lived, and hopefully will subside soon.Dr. Merav Ozair hasmore than 12 years of business and consulting experience and more than 15 years of teaching experience with both graduate students and financial professionals. Contact her atmr649nyu.eduorHoliSym.