Little Meaning in the Muck

Story Highlights:

• It's grown increasingly difficult to divine what's behind market direction and magnitude.
• Some of the downward pressure is likely unrelated to anything fundamental as markets lose predictive power to panic and financial "dislocations" that are still being worked out.
• Non-fundamental losses form the left side of the "v" shape characteristic of bear market bottoms—and though impossible to predict since they are by nature short term, steep gains on the right side inevitably ensue.
• When this extraordinary departure from reality runs its course, the market will return to fundamentals—it always does.

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Market volatility these days has become the norm. Intraday moves are quick and huge, with daily gyrations of 3% or 4% nothing short of routine—folks have almost become numb to any but the worst (or best) sessions. Painfully, the last two days fall into the former category.

Yet many continue trying to divine some hidden meaning in the ruckus. In our view, this is one of those times market movements don't make much sense—which isn't all that uncommon in any given short-term episode; this period is simply more volatile than normal. Some days markets drop on little news of note. Other days, there are stories that could materially affect stocks—like today's on an auto industry bailout—but the resulting magnitude of the move seems non-linear and hard to fathom. Maybe today's news increased uncertainty surrounding an auto bailout, but is it really worthy of an almost 7% one-day S&P 500 loss?

Human minds crave linear cause-and-effect relationships, but that does not always make them so. Some of the downward pressure is likely —now's a time when the market loses some of its predictive power to panic and other "dislocations." Examples of non-fundamental factors affecting markets could be hedge fund and mutual fund redemptions as panicked investors decide to pull their money from the market. Redemptions can result in the sale of good assets that have been held for a long time across all categories in fund portfolios.

These non-fundamental pressures are combining to push markets down steeply. On paper, the market has begun to form the "v" shape, typical of bear market finales, when trading for a time forgets fundamentals. The left side of the "v" (the bear market side) is often called capitulation. It's the final shakeout when most investors lose faith in a better day, claiming this time is different and things won't ever be as good as they were. But it's never different, and things always improve again. When markets finally clear (and they will), assets are left at bargain basement prices relative to earning potential. We appreciate that the current dislocation feels unnaturally long—it's a nasty characteristic of human perception to feel pain more than gain. But in fact, this unprecedented turbulence has only been a few months long so far.

Eventually, investors won't be able to help themselves and will start buying up cheap stocks thrown heedlessly overboard just weeks previously. And what happens then? A swift, steep climb back up forms the right side of the "v." It's impossible to time the tip of the "v." Often what drives the turnaround isn't seen clearly until much later because just like the way down, it isn't based on fundamentals. We don't know when it'll happen this time either. But to be in stocks when the right side of the "v" takes hold is to reap some of the biggest, fastest gains of any market cycle. And when this extraordinary departure from reality has run its course, the market will return to the fundamentals—it always does.