US stocks face AI of the volatility storm

U.S. stocks face AI of the vol. storm

Any doubt that U.S. stock market volatility is back for good ought to have been erased by Monday’s outbreak. It took CBOE’s VIX to its highest since the beginning of the month, helping confirm the importance of the index’s new ‘resting’ baseline, around 15. True, the ‘fear gauge’ is well off early-February’s spike to 50, but the refusal of vol. to go back to sleep helps explain why risky markets have failed to regain the poise they had for most of 2017. And eruptions like Monday’s are likely to become a more frequent occurrence.

Fed sensitivity

As per February, the key trigger of this week’s vol. surge is investors’ increasing sensitivity to faster Fed policy tightening than previously flagged. Investors are positioning for any nuance in Wednesday’s Fed statement that policymakers may conduct three more rises this year after the one that’s almost 100% baked in tomorrow.

AI levels rising

Yet heightened instability is also working its way into back markets in other ways. The increasing role of algorithmic trading has also returned to the spotlight in recent days. JPMorgan analysts went so far as to claim last week that artificial intelligence-driven hedge funds played a “big role in February’s de-risking”. The idea is that gyrations were exacerbated as models raced to unwind. JPM cited the 7.3% average fall by constituents of the EurekaHedge AI funds index in January. It was the sector’s worst monthly decline since the gauge was launched in 2011.  February also brought the worst declines for hedge funds styled as Commodity Trading Advisors (CTAs) since their key index was launched. They lost 6.5% on average. With a total of around $1.3 trillion in assets under management likely between these hedge participants, it’s easy to see how AI/algo trading could keep volatility simmering. More so, if we assume their strategies will switch to take advantage of volatility’s apparent return.

Chasing or leading?

Some backing for that view came from Chicago futures data for last week showing large speculators had accumulated the second highest net long VIX position ever. The record came in the wake of February’s mayhem. Increasing vol. expectations are the obvious explanation but they also beg the question of whether many ‘specs’ are chasing it in vain. Returns for long volatility strategies in February were virtually flat, according to EurekaHedge data. Indeed, even as the Dow Jones Industrial Average faces its first quarterly loss since 2015 it remains an incontrovertible fact that tax cuts and a confluence of global growth provide the best stock market backdrop for decades. Signs that optimism may prevail include a re-flattening curve between 2-year and 10-year Treasury yields in recent weeks. Softening term premium, even as the Fed tightens and the deficit climbs, shows it’s possible to over-estimate how far and fast risk appetite may fall.

Thoughts on Dow Jones futures’ technical chart

As often happens, chart inflection points are coinciding with fundamentals. Facebook’s self-inflicted woes came to a head in the same week as new Fed chair Jerome Powell may signal faster tightening. And last week, the Dow succumbed to a vulnerable medium-term trend by failing to hold above its closely watched 21-day exponential moving average (the red dashed line in the chart below). The threshold has capped the market since then (AKA resistance; see blue ellipse). Together with corroborated resistance at 25431 and 26154, before a crucial impediment at the Dow’s end-January all-time high, it will be a stretch for the market to regain the pace that prevailed beforehand. What the index has going for it is the (fairly) clean stretch of its long-term rising trend since February’s dives. Price support is literally rising in step with the market. Can it last? We will soon find out. Triangular formations like the one in this chart—comprised of a declining trend line from Dow’s cycle high and the climbing one we mentioned earlier—invariably lead to a ‘breakout’. Such denouements tend to bring a rapid acceleration of volatility, though the immediate direction is unpredictable. Clear divergence by trending indicators like the slow stochastic oscillator (see sub-chart) may not bode well. Still, the market has a long way to go before the long-term picture depicted by its rising 200-day moving average deteriorates. Even if selling pressure intensifies in coming days, declines severe enough to break the 200-day average are improbable. Another temporary break of the rising trend is more difficult to rule out though. If seen, it would almost certainly trigger more fireworks.