Markets Skipped The Stairs And Took The Elevator Down This Week. Here’s How It Happened.

Global stock markets took a battering recently, with Japanese stocks experiencing their worst-ever one-day loss. Not just that, but a volatility index hit its fourth-highest level in four decades, bringing back unwelcome memories of past crises like Black Monday, or the periods leading to the dot-com crash and global financial crisis. The lesson has been learned: markets can go from good to bad to worse in a blink – so let’s take a look at how.

Serious stock moves have historically happened when the market is fragile, and two factors can make that climate more likely.

Factor one: Unchecked greed and complacency

Historically, serious drops have often followed periods of unchecked greed and complacency. In other words, when investors are viewing reward as more tangible than risk, getting a little too comfortable with the market conditions.?

Take the current situation as an example. Investors have been encouraged by the US economy holding firm despite interest rates. Plus, they believed the Federal Reserve (Fed) would step in if markets faltered. So, full of confidence, they’re going all-in by taking aggressive risks, piling into trades that rely on low levels of volatility. In turn, these trades suppress volatility , and create the illusion of calm. So without any clear reasons to expect a downturn, investors have gone all-in on these bets, wrongly assuming that at the first signs of trouble, they can take money and run before everyone else clocks on. You can see how that belief could backfire –?especially with the gift of hindsight.

Factor two: Extreme positioning

Investors –?both professional and amateur –?have been crowding around the same obvious trades, diving into AI-driven stocks, momentum plays, large-cap quality stocks, and carry trades. That’s, in part, a self-fulfilling cycle: the more traders pile in, the more profitable these investments become, and the more folk are drawn to them. That’s led to extreme crowding, with some metrics indicating unprecedented levels of “one-sided positioning”. Then imagine the chaos of someone yelling “fire” in a packed theater: everyone rushes for a single exit at once. And with more sellers than buyers, there’s only one way for prices to go.

Now, a fragile market is like dry tinder: it sets the stage for a fire. But you need a spark to start the blaze, and when it comes to US markets, the following catalyst –?along with the unwind of the carry trade (more on that later) –?arguably played the biggest role in the sell-off.

The catalyst: A shift in the two main narratives?

Until recently, the market has been steadfastly optimistic. That was thanks to the promise that heavy investments into AI would result in even heftier returns one day, and the belief that inflation would land on target without forcing the economy into retreat. But both of those expectations have been challenged in recent weeks. Investors are now questioning whether AI's benefits can truly outweigh its massive investment costs. And recent data suggests the stateside labor market might be weakening faster than expected, suggesting that high interest rates have snuffed out more of the economy than intended. Layer on the fact that investment icons like Warren Buffett have been cutting ties with leading stocks like Apple, and investors have started to worry that the climate’s not as stable as they thought. And when you recall that investors have been growing complacent and crowding the same trades, a sudden shift in sentiment can put rallies into reverse

Now, price corrections – when investors move stocks closer to their perceived value –? are both inevitable and necessary. But when volatility spikes to levels last seen around the pandemic peaks, dot-com crash, or Global Financial Crisis, that’s outside the norm. And for a shift to be that dramatic, you need powerful accelerants.

Accelerator one: Technical feedback loops?

One standout factor was the unwinding of the carry trade in the foreign exchange market. Investors have been taking advantage of Japan’s ultra-low interest rates. They’ve been borrowing the cheap yen, and investing that money into currencies that can make them bigger returns. So when the Japanese yen picked up, investors scrambled to close their positions by buying back yen and selling other currencies. As losses mounted, investors were forced to sell off other assets, including Japanese and US stocks, to meet “margin calls” – that’s where brokers ask investors to add more funds to their accounts.?

But the yen tactic was one of many carry trades that started unraveling. Investors were also shorting volatility, sometimes indirectly through strategies that were selling call options on stocks. They were betting on correlations between assets to stay low, too. And when the sell-off picked up, both of those tactics worked against investors. The widespread unwinding of such trades was reminiscent of the short squeezes seen with meme stocks, when hedge funds were caught on the wrong side and forced to buy assets back at increasingly worse prices.

Other technical factors played a role, too. Many quantitative-focused funds follow rules that force them to sell when volatility rises or when prices start to sell off. Plus, there’s a point at which investment bank traders are forced to sell when prices fall – a little like what happened with meme stocks.

Accelerator two: Fundamental feedback loops?

The idea is that if fundamentals impact the sell-off, the sell-off is also likely to impact fundamentals. As Soros' reflexivity theory explains, investors' perceptions and market realities influence each other, creating feedback loops that amplify trends. Think of it like this: falling stock prices whittle away investors’ confidence and wealth, so they spend less and expect less from companies’ profit in the future, and as a result, they push stock prices down even further. So falling share prices can have the same effect as interest rate hikes, worsening fundamentals and adding more downward pressure on stocks.

The key takeaway here is that multiple feedback loops can magnify a price drop, especially when investor positioning is extreme, leverage is high, and complacency sets in. Add everything together, and that explains why markets often take the elevator down instead of the stairs.

So what should you do, then??

First of all, don’t panic: even big market moves aren’t reliable indicators of an imminent crash. (That said, you should be prepared for that eventuality.) And hey, even if we are headed into a bear market, panic-selling and chasing rallies are the biggest reasons why investors lose money. Remember, big drops are often followed by sharp rallies during bear markets, so you could lose a lot of money if you keep buying at the wrong times.?

Rather than lightning-quick reactions, you need a solid, well-defined game plan. Try to imagine different scenarios, from a big sell-off to an epic rally, and plan out your best course of action in each scenario. Decide in advance when you will and will not make trades. You would also be wise to consider reflecting on and taming your behavioral biases , as they can push you toward dangerous decisions during periods of high pressure.?

Now’s also the right time to sense-check your true risk tolerance. If a 10% dip has you sweating, you might have bitten off more risk than you can chew. That could become an issue: bigger losses will likely push you to sell at the worst time. To make sure you can handle them, reduce your level of risk either by shrinking the size of your positions or diversifying across geographies, sectors, and more importantly asset classes . At the end of the day, your top priority should be to make sure you’ve got the financial and mental capital to handle whatever markets throw at you.?

Key takeaways

• The scene was set for a violent correction to happen: greedy and complacent investors were piling into the same risky trades, wrongly assuming they could exit before everyone else at the first sign of trouble.?
• Trouble started to brew when the main two narratives that supported markets – AI and a resilient economy – were challenged. A rally in the yen that caught investors off guard was also to blame.?
• What could have been a normal correction was exacerbated by technical factors like “feedback loops”, which exacerbate losses and force even more investors to hastily exit their positions.