In the month of December the S&P dropped to 2351 from its summer high of 2930 putting the index just 0.3% away from entering a bear market. With no ongoing recession, it has left many investors scratching their heads about what led to such a severe drawdown. No one ever knows the exact reasons for these things, but here are some key players we see based on our reading.
First there’s the Fed. The only sure-fire cause of a recession in the U.S. is the Fed raising rates too quickly. This year growth outlooks have been tough to pin down with so much change from tax code and trade deals. With the Fed maintaining an aggressive posture, investors were worried that they would raise rates too quickly while these other changes were still hanging in limbo. This was the start of the dominos.
Once the first chip fell, other forces started to take precedent in the market. Those forces being algorithm-based trading. The Wall Street Journal reported on Christmas day that 28.7% of the trading in the market today is done by quantitative hedge funds. That is double what was reported from 2013.
That trading combined with high-frequency traders, index funds, and market makers accounted for roughly 85% of trading volume according to Marlo Kolanovic of JP Morgan. That means that 85% of trades placed this year had nothing to do with the fundamentals of the company or fund that was bought or sold.
I think we can all see how that can cause severe volatility in stock prices.
A third factor that furthered the decline, especially in December, was tax loss selling at year end. With new highs achieved mid-year, many funds had trimmed positions and built up gains to be paid. However, when the market quickly turned for the worse, many investors were looking at paying for a gain in a year when the fund they own actually had a loss by year end. According to many sources this has led to a record year for tax-loss selling which furthered the market selloff in general.
Hopefully this starts to paint a picture of how such a large selloff could occur on little fundamental change in the market. With the continued expansion of algorithm-based trading, market drops are increasingly related to technical aspects much more so than how things are fundamentally affecting companies.
As investors, it’s important not to let drops like this scare us into thinking the world is ending. There is much more at play now than there was even 5 years ago and sticking to the fundamentals is still the way to get through tough times like these.