Volatility has returned! After a very benign market that has generally proceeded higher with very few interruptions, February brought some very sharp pullbacks, even to the point of a correction. While this is normal, investors had been lulled into a false sense of security. Below is a chart of the VIX which measures the market volatility, it is striking!
This reminds investors that gains are earned over time, but losses can crop up shockingly fast. Why is this? There are several culprits, all of which play a role.
Leverage and Margin Calls: When returns have been steady, investors begin to buy more stock on margin. This margin leverages their investments, and provides exponential returns when investors are right. On the other side, however, when the market begins to drop, brokerages that have loaned this money begin to issue margin calls. These margin calls usually require investors to sell stocks at the worst possible time. If there are enough margin calls, it can add fuel to the fire, and actually worsen the drop.
Algo Programs: Hedge funds, and Institutional Investors have created finely tuned models that issue buy and sell requests automatically based on market conditions. Unfortunately, the people that designed these models know that pullbacks happen quickly. So when the algos see a downturn, they wake up and start rapidly issuing sell orders. Again, too many people are heading for the exits, and there aren’t enough doors!
Investor Sentiment: Finally, this is the granddaddy of culprits. Before algos were created and before leverage exploded, investor behavior has caused drops. People care more about fear than greed. This makes them quick to sell when they see the market going down, and they sell in larger bunches when compared to when they see opportunity in the market. If you think about some of the famous crashes, (e.g. 1929), it all started with market psychology changing, and investors reacting rapidly. This is still evidenced today, and the most recent correction was definitely impacted by sentiment.
Now that we have had the market correction, it is time to start the slow rebuilding process. Just remember, the forces of rapid corrections will always be lurking!