A sharp drop in U.S. stocks is provoking selling from volatility-sensitive funds, exacerbating a selloff that has already brought the Nasdaq Composite into correction territory.
Volatility control funds - systematic investment strategies that typically buy equities when markets are calm and sell when they grow turbulent - have gorged on stocks as indexes soared to record highs in 2024.
More recently, they have begun selling, as worries over the economy and tech earnings rattle investors: volatility control funds have dumped about $83.6 billion of U.S. equity futures over the last two weeks, according to Charlie McElligott, managing director Cross-Asset Strategy at Nomura.
It’s “extremely rare” for the funds to sell in that size, McElligott said, noting that they have only recorded a sharper pullback in their equity allocations 3.2% of the time in the last 10 years.
The moves come on the backdrop of a selloff in U.S. stocks that deepened on Friday, after weaker than expected U.S. employment data spurred recession fears. The S&P 500 has slipped about 5% from its July 16 record high, while the tech-heavy Nasdaq Composite Index, has slipped about 10% from a record high reached last month, putting it on pace to confirm a correction.
The Cboe Volatility Index stands at its highest level in more than 16 months.
The funds’ behavior going forward depends on how volatile markets are in the next few weeks, McElligott said.
A 1% daily change in the S&P 500 over the next two weeks could spur another $15 billion of selling in that period, while daily 0.5% changes would stop the bleeding and see these funds turn buyers to the tune of about $14 billion, McElligott said.
Certain other slower-reacting volatility-sensitive strategies could also join the selling if the market selloff worsens.
Equities trend-following commodity trading advisers (CTAs) sold only about $12.5 billion over the last two weeks. But these systematic, rule-based investment strategies could ramp up selling to about $36.0 billion if the S&P 500 were to sell off another 4% over the next two weeks, McElligott said.
A selloff that rocked equity markets around the world is clouding the outlook for investors looking to buy stocks on the cheap, as worries over the U.S. economy and disappointing tech earnings threaten more losses ahead.
A two-day rout late last week left the S&P 500 nearly 6% from its July peak while the tech-heavy Nasdaq Composite extended losses to notch its first 10% correction from a record high since early 2022. Equities plunged in Europe and Asia as well, with Japan’s Nikkei index losing nearly 5% for the week.
The market tumble presents a dilemma as another week of trading is set to unfold. Jumping into stocks during periods of weakness has rewarded investors over the last two years, as the S&P 500 has climbed about 50% from its Oct 2022 low.
But buyers of the dip risk being steamrolled if recession fears grow following last week’s run of alarming U.S. data. The S&P 500 has fallen an average of 29% during recessions since World War Two, according to Truist Advisory Services.
Saturday’s earnings report from legendary investor Warren Buffett’s Berkshire Hathaway may also give bargain hunters pause: the conglomerate sold about half its stake in Apple and let its cash pile soar to $277 billion in the second quarter. Berkshire often lets cash build up when it can’t find whole businesses or individual stocks to buy at fair prices.
“People are starting to reassess what their risks are and whether they are properly positioned.” said Mark Travis, a portfolio manager at Intrepid Capital, noting also that elevated valuations are giving investors pause.
Stocks have soared this year in a rally fueled by excitement over artificial intelligence technology and a so-called Goldilocks economy where growth stayed resilient while inflation cooled.
The market’s appetite for risk took a hit this past week. Concerns that the Federal Reserve may be hurting economic growth by waiting too long to cut interest rates pushed traders to dump everything from richly-valued chipmakers to shares of industrial companies and head to safe harbors such as U.S. government bonds.
Selloffs after disappointing earnings from tech-focused companies such as Amazon, Alphabet and Intel, meanwhile, exacerbated concerns that stocks may have become too richly valued.
BRIGHT SPOTS
Nevertheless, some investors believe the recent tumble is merely a pause in a strong year for markets, and are looking for the opportunity to buy.
“We’ve been looking to potentially get into some of those expensive names and frustrated we haven’t had an opportunity, and now we’re getting there,” said Lamar Villere, portfolio manager at Villere & Co.
The S&P 500 and Nasdaq are both up around 12% year-to-date even with the recent selloff. Chipmaker Nvidia, whose blistering climb became emblematic of the AI craze, is sitting on a year-to-date gain of about 117%, despite falling more than 20% from its high.
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