One of my old colleagues at Citigroup, Peter “Fish” Whiting, once took me aside as an exuberant 22-year-old on the trading desk and told me: “Just remember, mate, even the pretty girls get hurt in the bus crash.”

In market terms that means when the correction comes it is indiscriminate. High-flying stocks get “hurt” alongside everything else as risk is priced back into the asset class. The stocks that have led the market lead the correction, and people sell where there is liquidity and where they have profits to lock in.

You must understand that what we are witnessing is the start of a long-overdue trading correction in global equity markets, led by the highest risk markets. This is NOT the start of a bear market or anything more serious. The trading “rubber band” has been extremely stretched, driven by the false assumption that “excess liquidity” would underpin markets. Clearly, that “excess liquidity” was nowhere to be seen in global markets last night or today.

With the trading “rubber band” so stretched, expansion of price/earnings (P/E) multiples being seen everywhere and access to leverage being the highest in modern history, it must be no surprise that when the trading correction comes it is violent and sharp. It’s almost self-fulfilling, and shows you just how much leverage has been at work over the past six months.

The global trading correction that started on Tuesday night was like a “domino effect”. It started in China A shares and it ended at Wall Street. It was like watching dominos knock each other over and at the end the biggest domino fell. This is exactly how the May trading correction started last year, and the clear lesson was that this led to a “psychological change” in investor attitudes for the next three months.

Investors had broadly let down their guard. In boxing terms they had dropped their hands and were swinging wildly at any target. They had priced out risk, with the equity risk premium narrowing dramatically versus risk-free government bonds. Then, completely unexpectedly to most, the market lands a stinging punch in the guts, which knocks the wind out of over-leveraged investors.

You must understand the psychological effects of this punch. This makes people reassess what is risk; reassess their portfolios, and reassess appropriate leverage. It makes people think about whether the market can go lower rather than whether it can go higher. It leads to a more cautious strategy from all market participants for fear of the market falling further. Excessive optimism is removed, and that simply means some equity risk premium is priced back in.

This risk readjustment phase will NOT be a one-day event, and while we probably won’t get another day quite as dramatic as today, it would be highly unwise to believe this will be a one-day event.

I believe the next three months will play out along the following lines. “On the third day markets will bounce”. But you can’t be sucked into the sucker rally. After a few weeks of heavy volatility markets will find a short-term level, perhaps 6% below recent highs. We will then see a 2–3% rally off those trading lows, which will make everyone believe the worst is over, and then we will get the REAL trading correction where the market loses another 7% to take the trading correction to 10% from top to bottom. This is exactly how last year’s correction played out between May and August.

Peter Fray

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