Why and What Now?

Tips amid the stockmarket slump aftermath...

TURNS OUT that Friday's dip was just a warm up for the bigger event, writes John Stepek, executive editor of MoneyWeek magazine.

The Dow Jones crashed by 4.6% on  Monday (that's a points drop of 1,175), while the S&P 500 dropped by 4.1%. That's the biggest drop since August 2011, when the US lost its triple-A credit rating.

Meanwhile markets everywhere else sank into the red too, dropping further on Tuesday.

But the biggest action was in the Vix index. The measure of market volatility – often described as Wall Street's fear gauge – soared.

And chances are, it was at the heart of the sell-off.

Let's go straight to the epicentre of this particular market crash. Volatility.

You may have noticed, but markets have been very calm over the last few years. They have steadily risen in a well-behaved manner and haven't done much to scare the horses.

In other words, they haven't been volatile.

As a result, the Vix index – which is one measure of volatility – has been very low. Where there's a trend, you'll find people who want to bet on it continuing. And Wall Street, being the sort of place that it is, found ways to bet on the Vix.

Now, Hyman Minsky sums up everything you really need to know about markets and human beings, with his notion that "stability breeds instability". And that sums up the reason for the market crash.

People saw volatility being low. Rather than think: "That'll be high again one day", they mostly decided to bet on it continuing to stay low, or going even lower.

Now you can bet on low volatility in lots of ways. You can outright short the Vix index. But you can also use investment strategies that only work when volatility is stable or falling.

And because volatility has been so low for so long, lots of people were betting on that continuing.

The thing is, when lots of people are betting on volatility remaining low, that actually helps to push it lower. As Bloomberg's Tracy Alloway points out, the Vix is "self-reflexive". In other words, betting against volatility going up helps to keep volatility down.

The problem with that is that it means that if something does push volatility up hard, then it acts like a coiled spring – all that suppressant activity gets blown into the air and the Vix spikes harder.

That appears to be what happened yesterday. Without getting too technical (I've barely had one cup of coffee this morning, I'll only get my gamma mixed up with my delta), the mild bond and equity drop on Friday pushed volatility up a bit. That in turn, encouraged many of the "low volatility" strategies to pull back.

The market tipped over as a result, and we got a big sell-off. And ironically enough, the bond market – which was arguably the "fundamental" trigger for all this – has bounced back as everyone fled to a safe haven.

Well, the people who've been hit hardest are retail investors who were betting on the Vix continuing to fall using short-Vix exchange-traded notes. These are the sorts of things we don't recommend you buy because they are opaque, expensive, and they blow up when they go wrong. So I hope you didn't own any of them, because most of them look as if they're going to be worth zero at this point.

The follow-on question is: how many other low-volatility bets are still to be unwound and what sort of effect might this have on the market? I can't answer that right now.

However, overall, this feels like a crash that has been driven by technical factors rather than a big fundamental nasty. This feels like forced selling due to markets taking investors by surprise, rather than investors deciding to get out.

That doesn't mean that the stock market isn't expensive (in the US, certainly). And it doesn't mean that rising bond yields aren't going to be a problem. There are fundamental issues here for sure.

But at the same time, it's not 2007 or 2008. The economy is still strong. And while the structural issues caused by low volatility punts might well have further to go, it's not on the scale of the subprime crisis.

I also suspect that there is still a strong "buy the dip" mentality out there. If anything, the rally in bonds and the hope that the Fed will now come and save the markets from any hint of a fall will keep the show on the road for that bit longer.

Put simply – it's still going to be inflation that does for this bull market in the end. And that particular doom is still a little further into the future.

So what should you do now? This is where you break out your "watch list". That's the list of stocks that you would like to buy, but you don't think they're quite cheap enough.

When people are being forced to sell by weird market glitches like this, that's when you get to pick up valuable assets at decent prices. So if there's a quality stock that you've had your eye on and it's been swept up in the market sell-off – or an appealing investment trust whose discount has suddenly ballooned – then now could well be a good opportunity to put some money to work in it.