What’s behind the market madness?

August 31, 2015, 9:21 am David Taylor Yahoo7 Finance

Australians are worried about market volatility. But what caused last week's drama and can we now relax?

Forgive me if I use the word “extraordinary” too many times in this column, but what a week we had last week.

We saw some of the biggest financial market swings in history.

At one point the Dow Jones Industrial Average on Wall Street climbed over 400 points only to finish the day 200 points in the red.

That followed an absolute pummelling on the trading floor on Monday.

Across the Pacific, $1 trillion was wiped off the value of Asian markets.

The Shanghai Composite was falling anywhere between five and 10 per cent on a daily basis.

Back home, around $60 billion was wiped off the value of the Australian share market at the start of the week – a wipe-out not seen since the US debt crisis in 2011.

Also read: Do Australia’s biggest companies deserve your investment dollar?

So what’s the problem?

The central theme is that there are concerns the Chinese economy is slowing too fast.

There was heightened anxiety two Fridays ago when China released some fresh data on the health of its manufacturing sector.

The figures revealed factory activity shrank at its fastest pace since the height of the financial crisis.

Investors are concerned that slow growth in China will infect some of the world's biggest economic centres, like the United State and Europe.

Indeed there were concerns too that an imminent interest rate increase from the Federal Reserve in the United States could put a nail in the coffin of world economic growth.

Bulls fight back

By mid-week the mood had changed. Roaring bears and plummeting markets were replaced by huge battles between bulls and bears.

Massive swings on global markets were a reflection of traders desperately trying to work out whether the world was coming to an end or if it was just a figment of their imagination.

Then, later in the week, wild swings were replaced by rising markets.

Despite huge losses last Monday, the Dow Jones Industrial Average managed to stay in the black overall for the week. In fact Wednesday and Thursday last week saw the best two days for the Dow since 2008.

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Well during the week Chinese authorities stepped in to stem the bleeding on the country's biggest share market and to sure up the economy.

Recently revised economic growth data also showed the US economy grew at a much stronger rate between April and June than had previously been forecast.

Can we relax?

Of course we can, but not about the financial markets.

Even a casual glance at the market last week would tell you something’s a-miss.

A stockbroker told me last week that levels of volatility – from a long-run average perspective – were actually returning to more normal levels.

The reality, however, is that fear is heightened beyond all reasonable levels.

Two weeks ago the VIX Index (fear gauge) rose the most amount in history. That ain’t right.

‘Free’ markets are anything but at the moment. Markets still crave easy money and the ‘crutch’ of central bank assistance.

Yes, the cheap money and increased activity on share markets have made for some thrilling stock market rides in the recent years, but the last few weeks are a potential signal for what’s ahead.

The market’s become hyper sensitive to news and, frankly, is suffering from some sort of anxiety disorder.

Years and years of being wrapped up in cotton wool will do that to you.

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China still standing tall

I should point out that although the Chinese economy is facing some serious challenges, it’s not in dire straits just yet.

The world’s second largest economy is growing anywhere between three and seven per cent, and still has around $US3.8 trillion in excess foreign reserves.

China’s also still got very high interest rates.

So compared to say Japan, or the United States, or Europe, China’s got a lot of levers to pull.

Australians are worried

Some stock brokers will tell you that everything’s just fine. I don’t buy that.

I’ve spoken to numerous portfolio managers over the past week or so and they all say the same thing.

They tell me that while we may just be in the middle of a share market correction (as opposed to a bear market), the ASX 200 as a whole is overvalued at the moment.

That’s not to say it’s in a bubble – not by any means, but you certainly have to pick your stocks carefully.

I’m told the banks have little upside to them in the medium term.

The big miners too are still looking a bit bloated.

If you have your heart set on buying stocks, consider looking at small to mid-tier companies that have their house in order.

The consumer discretionary space certainly has some interesting companies.

But buying the big blue chip stocks on the market with the ‘set and forget’ strategy is not really possible just at the moment.

What you need to know

There was a considerable rally on the ASX 200 last week.

Investors panicked on Monday, but found their footing on Tuesday.

That’s partly because Australians are a resilient bunch, but also because it was clear that some sort of Chinese intervention was on the way, and the falls we had seen simply weren’t warranted from a valuation point of view.

That doesn’t make the market any less dangerous though.

The advent of computerised and algorithmic trading, cheap money and extreme levels of monetary policy, combined with politicised markets, make wild share swings inevitable.

A portfolio manager told me early last week that the share market is still a legitimate asset class, but if you’re not prepared to handle the occasional ‘roller-coaster ride’ perhaps the share market isn’t for you. Harsh but fair.

Stock Quotes

e.g. BHP, CBA