On Wednesday, the S&P 500 declined 1.3%, leading some traders to say we’re already seeing fear. Oh, how soon we forget what true fear in the stock market looks and feels like.
After all, the market is less than 4% from all-time closing highs. And despite September’s losses, the S&P 500 has now posted seven straight quarterly gains.
Arguably, we haven’t seen real fear since late 2011.
However, volatility is picking up in the short term, and everyone is searching for proximate causes…
Are investors, once again, noticing the slow-motion train wreck in the eurozone economies? Is the selloff due to fears that Ebola is spreading in the United States?
Whatever the news headlines, the ultimate cause of the selloff is actually more serious than hemorrhagic fever (from the market’s perspective).
That’s because the primary driving force behind higher stock prices and narrower credit spreads for the past few years is coming to an end.
I’m talking about the end of quantitative easing – the Federal Reserve’s bond buying stimulus program.
Check out the chart below, which has been making the rounds on trading desks:
It shows what seems to be a very close relationship between the S&P 500 Index and the size of the Fed’s balance sheet.
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Some investors and traders are even saying that this is the only chart that matters.
As you can see, since the end of the credit crisis, the strongest stock market gains have tended to coincide with periods of aggressive Fed balance sheet expansion.
With QE set to end this month, volatility is to be expected, as I said back in July.
FLASH CRASH 2.0?
In fact, we can’t rule out another sharp decline like the so-called Flash Crash on May 6, 2010, when the S&P 500 declined as much as 8.6% intraday before bouncing back.
A joint report by The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) found that orders from trading firm Waddell & Reed triggered the swiftest portion of the plunge. But the true cause is likely far more complex.
The Flash Crash also occurred during another period of Fed inaction, but it wasn’t the end of the world. Nonetheless, it was a horrific day for many investors and traders, and this is one of the reasons why the end of QE may be even scarier for the markets than the spread of a deadly disease that causes you to bleed out.
After all, malaria kills more people in a single week globally than Ebola has killed during this entire outbreak.
Alan Gula, CFA