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Just Like Before, the Market is about to Crash - Outside View by Asad Dossani

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Just Like Before, the Market is about to Crash
May 17, 2017

Understanding markets is like solving a puzzle. It's putting together many pieces of information to get to the big picture. Sometimes the pieces fit easily, and the puzzle practically solves itself. But other times, the pieces just don't fit. The picture doesn't quite make sense. The market behaves in ways that seem counterintuitive.

This is one of those times. Earlier this week, the VIX index fell to new lows. The VIX is the market's expectation of future volatility based on S&P 500 option prices. The India VIX is the same thing but based on Nifty option prices. It too is near its lows.

The VIX is sometimes called 'the fear index'. When the VIX is high, the market expects high volatility. Typically, this happens if the market is fearful of some major event or problem.

Today's puzzle comes from the seeming disconnect between the VIX and fundamentals.

In the West, political uncertainty is higher than it's been in recent history. President Trump is highly unpredictable. In Europe, far-right nationalist parties are gaining ground. In the UK, Brexit continues to progress. Economic uncertainty persists. Examples include the rise of automation and the threat of trade wars. Most central banks remain committed to ultra-loose monetary policy in response.

But you would never know it looking at the markets. They're at record highs. Fear levels are at record lows. What's going on here?

The most common explanation is that markets are mispriced. When there is a disconnect between fundamentals and price, markets will move. Stock markets are likely to experience a big correction. And volatility levels will return to normal when this occurs.

But there's a problem with this story. Which is that this is not a new phenomenon. This has been the case for the last couple of years. When Trump won the US election, markets initially crashed. They rebounded almost instantly, and then carried on to record highs. Following Brexit, the UK's FTSE 100 kept hitting record highs.

If the problem is mispricing, then markets have been mispriced for years. Which means there's no way to predict when this ends. These same facts would indicate a market crash earlier this year. Or last year. But it's yet to happen.

Maybe we are missing a piece of the puzzle. Something else that explains this disconnect between fundamentals and prices. More on that next time.

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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1 Responses to "Just Like Before, the Market is about to Crash"

Dhananjay Patwardhan

May 26, 2017

Sir, You have rightly pointed out that the VIX index fell to new lows. It is just waiting for a few moments that the expected is to experienced by all as a bitter pill. The Physics has a law which states that anything which swings up very rapidly is sheerly by gravitation force falls back more than the speed of its earlier surging. This law or principle or simple logic applies here .

I personally thank you for raising an alarm on time.

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