Market Perspective for August 28, 2015

It was an incredibly volatile week for the markets. China’s stock market plunged at the end of last week, spooking global financial markets. After several days of declines, the Chinese government intervened in the market, investors shifted their rate hike expectations and stronger U.S. economic data pushed up GDP growth estimates. China’s stock market cannot directly impact global markets because very few foreigners hold shares listed in China. Foreign investors are also lightly impacted by Chinese debt and property. Foreign markets are exposed via exports to China, mainly commodities and industrial goods. Mining shares have suffered the greatest losses; Freeport McMoran (FCX) traded at $21 per share two months ago and hit $8 this week before rallying, a loss of 62 percent from high to low.

Global markets are also exposed to China’s capital flows. The country has been selling U.S. treasuries in order to defend the value of the yuan. This is having a negative effect on emerging market currencies, which sold off on concerns the Chinese yuan would continue depreciating. Chinese selling could theoretically push up U.S. interest rates, but for now, investors are buying U.S. treasuries in response to moves by China which are destabilizing global markets. As long as China’s economy remains a concern, U.S. treasuries and the U.S. dollar will be sought after as safe haven assets.

The beginning of trading on Monday saw mini-flash crashes in individual stocks and ETFs. High frequency traders (HFTs) constitute a considerable portion of market volume these days, but when conditions turn extreme the machines are turned off. Perhaps the best example of this phenomenon relates to preferred stock ETFs, such as iShares S&P U.S. Preferred Stock (PFF). Preferred stock is often issued by financial firms and these stocks were volatile in 2008 as investors feared for the solvency of banks. Since then, Federal Reserve and U.S. Treasury support guaranteed banks wouldn’t go under, yet in 2010, 2011 and now again in 2015, PFF experienced a very sharp drop in price over a very short period of time during a mini-panic in the market. Other popular ETFs were also momentarily crushed, such as iShares Select Dividend (DVY) and SPDR S&P Dividend (SDY).

Why were these funds impacted so harshly?

Many retail investors use stop losses on ETFs to protect against losses. When the HFTs turn off their machines, the only bid in the market may be a lowball buy order. It only takes one stop loss hitting a bid to trigger a large increase in stop loss selling. Retail investors see their shares sold into a market with no liquidity, which results in a plunge in price as a wave of selling hits a momentarily quiet market. Until markets or regulators change the way stocks are traded, these types of events will remain a threat to prudent passive investors looking to protect their capital.

On Monday, even the very heavily traded PowerShares QQQ (QQQ) briefly fell double digits, way out of line with the Nasdaq, which it closely tracks. For investors, an easy way to check an ETF is on Yahoo! Finance. For example, pull up a quote of SDY. To pull up its net asset value (NAV), enter ^SDY-IV (it does not need to be capitalized).  This is called the “indicated value” and it is only available during the trading day, but it can serve as a very useful check to see if a fund you hold is falling due to a drop in the NAV or due to investor panic during a momentarily illiquid market.

Once investors overcame their panic on Monday, they experienced a failed rally on Tuesday and then a full-fledged one on Wednesday and Thursday. One of the biggest recoveries was in the oil market, where prices recovered from a low of $38 all the way to $43 on Thursday, back to levels seen a few weeks ago. Oil pushed to $45 on Friday following news that Saudi troops have invaded Yemen.

Indexes such as the Nasdaq and S&P 500 Index have experienced 50 percent retracements, a level that traders watch for a pullback. This explains the small gains and losses in early Friday trading, as bulls and bears battle over this short-term line.

Finally, U.S. economic data was solid in July. Durable goods orders came in far above estimates; economists were looking for a 0.6 percent drop, but orders rose 2 percent. The good news caused the Atlanta Fed to raise its GDP Now forecast of third quarter GDP growth to 1.4 percent.  Second quarter GDP was also higher than expected, coming in at 3.7 percent, much stronger than the initial 2.3 percent estimate. Strong economic data and a rebound in equities means a September rate hike is still very much a possibility. Speculators have shifted their bets towards December and January, but Fed officials have not closed the door on a September rate hike.

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