A rally in stocks on Tuesday may take shape after an ugly Monday selloff, but any rebound ought to be treated with a heavy dose of skepticism, and as preparation for the next wave of selling, warns one quantitative analyst at Nomura.
Macro strategist Masanari Takada, in a note on Tuesday, said Monday’s tariff-inspired tumble played out as he expected, but he speculates that the volatility spike that Wall Street investors experienced, after President Donald Trump last Thursday announced 10% tariffs on China imports not already subject to trade duties, is nothing compared with what could be in store later this month or next.
Takada explained it this way:
Once the first wave of volatility has passed, global equity markets are likely to experience a spontaneous rebound. Contributing factors to such a relief rally could include expectations for a substantial rate cut by the Fed at the September FOMC meeting and stock purchases made by short-term contrarian investors. However, for the three reasons we spell out below, we would expect any near-term rally to be no more than a head fake, and think that any such rally would be best treated as an opportunity to sell in preparation for the second wave of volatility that we expect will arrive in late August or early September. We would add here that the second wave may well hit harder than the first, like an aftershock that eclipses the initial earthquake. At this point, we think it would be a mistake to dismiss the possibility of a Lehman-like shock as a mere tail risk.
The Nomura analysts says that part of the thinking behind his call is that a number of hedge-fund investors poured money into the stock market in June and July, as it was rallying on the hope for an interest-rate cut from the Federal Reserve’s rate-setting committee and the promise of more easy-money policy moves to come.
However, Fed Chairman Jerome Powell appeared to throw some cold water on the notion that a cycle of monetary-policy easing was in store for investors, describing a cut doled out on July 31 as a “mid-cycle adjustment.” Adding to that notion, St. Louis Fed President James Bullard told the Agence France-Presse that the Fed “can’t realistically move monetary policy in a tit-for-tat trade war.”
A combination of disappointment over a Fed that hasn’t been as dovish as hoped and an unexpected intensification of Sino-American trade conflicts have buffeted markets, catching some investors off guard, with a lot more room to run lower.
“Like hedge funds, trend-following algos including CTAs and risk-parity funds have been sucked into the aforementioned chain-reaction selloff. Even so, CTAs’ net long position in S&P 500 futures is still only about 45% smaller than it was at its most recent peak on 16 July. With much of the unwinding still left undone, we think CTAs are likely to continue selling futures for loss-cutting purposes,” Takada wrote.
CTA refers to commodity trading advisers, which are essentially hedge funds that use futures and options to gain exposure to the market.
The analysts says the unwind of long bets in stocks and those that reflect hopes of an extended period of lower volatility to persist haven’t taken hold after the previous session’s shock lower.
On Monday, stocks had their worst day of the year, with the Dow Jones Industrial Average
shedding more than 767 points. The Dow ended the day down 2.9%, at 25,717.74, while the S&P 500
declined 87.31 points, or 3%, to close at 2,844.74. The Nasdaq Composite Index
lost 278.03 points to finish at 7,726.04, a decline of 3.5%.
Takada said that spikes in the Cboe Volatility Index
, a measure of implied stock-market volatility, tend to come in pairs in August, “once in the first half of the month and once in the latter half.” The VIX jumped from 17.61 at the end of last week to 24.59 on Monday but was most recently at 22.08, holding above its historical average.