Is the WeWork fiasco a warning of wider market volatility ahead?

Wednesday’s 3.2% fall in the FTSE 100 is getting the new month off to a bad start and it may prompt some investors to think of the comment made by Mark Twain’s character Pudd’nhead Wilson: ‘October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.’ Despite the plunge, the FTSE 100 index is still up for the year and volatility is still very subdued by historic standards.

Quiet equity markets tend to provide better returns than choppy ones – but unusual calm can lead to unusual risk-taking, which in turn leads to over-exuberance, poor capital allocation and eventually volatility’s return with a vengeance as poor (or simply over-valued) investments falter and confidence finally cracks.

In general, there do seem to be four clear ‘cycles’ when it comes to market volatility

• A period (often lengthy) of total calm, where headline indices do not gyrate, as they made steady, consistent upward progress
• A period where the first doubts about the bull market creep in, sellers begin to challenge buyers with their force of their opinions and headline benchmarks make progress but at a lesser rate and with greater effort. Ultimately, this proves too much for nervy buyers and holders, who crack and start to sell.
• A period where doubts finally give way to panic. Volatility becomes the norm as share prices and indices gyrate wildly, but with a clear downward bias. Finally, the wet towels come slopping into the ring as buyers capitulate and turn seller at almost any price.
• Markets bottom amid this final frenzy. Calm descends as buyers begin to regather their nerve as they find assets that are once more attractively valued, and markets begin their next march higher.

It is not hard to work out where we are now.

Even if the 3.2% fall in the FTSE 100 was eye-catching, that was just the thirty-first time this year when the index had moved by 1% of more from open to close in 2019 and just the eighth when it had gained or lost more than 2%.

Source: Refinitiv data

Since 1995, the FTSE 100 has, on average, moved by more than 1% in a day 86 times a year, with 16 of those gains or losses being or more than 2% in a day.

Source: Refinitiv data

It therefore does not quite feel as if the stock market is about to immediately turn down but experienced investors will also remember how long periods of below-average volatility in 1993, 1996, 2005-06 and (to a much lesser degree) 2017 and 2018 preceded sudden market dislocations of varying length and depth.

Trouble often starts in far-flung places, which often only do well when liquidity is abundant and risk appetite is running high and which quickly falter when both go into reverse. In response to that trouble, investors huddle in a diminishing circle of assets that are perceived to be ‘safe,’ which ultimately prove to be the final dominoes to fall.

It remains to be seen whether the WeWork fiasco provides a tipping point but the high coupons demanded by investors before they funded Aston Martin and Metro Bank, the latest sharp drop in Bitcoin (down by nearly 25% in a month in dollar terms) and ructions in the US inter-bank funding markets suggests that either liquidity is getting tighter or confidence is wobbling a little or both. Strength in the dollar and a resilient gold price would also suggest there is some demand for haven assets.

Any sustained pick-up in volatility could therefore be a warning sign and, after the market’s loss of faith in some more esoteric or risky asset classes and investments, investors might like stress test their portfolios, to ensure that they have not over-reached themselves and that risk is properly calibrated according to their well-defined long-term goals and target returns.

These articles are for information purposes only and are not a personal recommendation or advice.