What Really Caused Monday's Dow Selloff?

Summary

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WSJ Your Money Briefing: What Really Caused Monday's Dow Selloff?

Date: February 7, 2018
Host: JR Whalen
Guest: John Cindrejo, Wall Street Journal Reporter

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Episode Overview

This episode tackles the causes behind the then-record 1,100 point selloff in the Dow Jones Industrial Average. Host JR Whalen and WSJ reporter John Cindrejo analyze the forces driving the dramatic decline, focusing particularly on the role of complacency among investors, volatility trading, and the feedback loops created by financial products linked to market calm.

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Key Discussion Points and Insights

1. Underlying Causes of the Selloff

• Inflation and Bond Yields as Factors
  • Higher bond yields made stocks comparatively less attractive, sparking some investor concern (00:40).
• Complacency and the Calm Before the Storm
  • John references economist Hyman Minsky: “Stability brings forth its own instability.” (01:07)
  • For two years, markets were largely calm, leading investors to bet on continued tranquility.

2. Volatility Products and Feedback Loops

• The Volatility Trade Explained
  • Many investors sought extra returns by betting against volatility, through products linked to the VIX, the “fear index.”
  • When volatility actually spiked, these positions became “losing bets” that needed to be unwound, amplifying the market drop (01:50).
• How Feedback Loops Work
  • Forced liquidations in these products can “hurt the broader market,” creating a reinforcing cycle of volatility and selloffs (03:33).

Notable Quote:
“Stability brings forth its own instability...when suddenly [markets] don’t stay calm for whatever reason, suddenly you lose a lot of money and then you need to offset all those bets...it’s a reinforcing feedback loop.”
— John Cindrejo (01:08)

3. The VIX and Derivatives Market

• Mechanics of the VIX
  • The VIX is a derivative—investors trade on expectations of future volatility rather than the underlying index itself (03:08).
• Insurance Analogy
  • John likens betting against volatility to “selling hurricane insurance”: typically profitable, but catastrophic when disaster strikes (03:11).
  • If sellers aren’t “ready for it”—lacking liquidity—this can escalate moves in the real market.

Memorable Moment:
“In financial markets, the actual insurance can make tornadoes appear or disappear because the different markets are connected underneath.”
— John Cindrejo (04:51)

4. Connection to the Broader Market

• Banks' Role
  • Banks facilitate both sides of the volatility bet, hedging exposures created by their customers (05:44).
  • By offsetting volatility positions in the stock market, banks knit the volatility and equity markets even closer, sometimes exacerbating price swings.

Notable Quote:
“There needs to be two to tango...banks are the ones who actually connect both markets.”
— John Cindrejo (05:47)

5. Investor Psychology and Reactions

• Recurring Patterns
  • The episode highlights how market euphoria and underestimation of risk repeatedly leave investors exposed to downturns (06:48).
• Rationality vs. Reality
  • Markets aren’t the perfectly rational entities envisioned in textbooks; liquidity needs and unpredictability make perfect foresight impossible (07:19).

Notable Quote:
“The reality of the market is that we like to think about it as this...perfect place where extremely rational people encounter each other...but reality is that the market has a lot of irrationality to it.”
— John Cindrejo (07:22)

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Timestamps for Key Segments

• 00:40 — Introduction of the topic and initial discussion of inflation, yields, and investor calm
• 01:07 — Hyman Minsky, complacency, and instability in markets
• 03:08 — Explanation of the VIX and analogy to hurricane insurance
• 04:51 — How insurance dynamics in financial markets differ from the real world
• 05:44 — The role of banks in connecting volatility and stock markets
• 07:19 — Discussion of investor behavior, rationality, and recurring market patterns

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Overall Tone and Conclusion

The episode maintains an informative, slightly cautionary tone throughout, emphasizing the unpredictable nature of markets and the dangers of complacency. John Cindrejo repeatedly returns to vivid analogies and straightforward explanations, making complex financial dynamics accessible—even as he underscores the ever-present risk of future market storms.

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Standout Quotes

• “Stability brings forth its own instability...it’s a reinforcing feedback loop.” — John Cindrejo (01:08)
• “In financial markets, the actual insurance can make tornadoes appear or disappear...” — John Cindrejo (04:51)
• “There needs to be two to tango...banks are the ones who actually connect both markets.” — John Cindrejo (05:47)
• “The reality of the market is...the market has a lot of irrationality to it.” — John Cindrejo (07:22)

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Listeners are reminded to stay alert for market uncertainty, as volatility is always lurking below the surface, waiting for its moment to reappear.

Transcript

[Announcer]

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[JR Whalen]

Welcome to youo Money Matters. I'm JR Whalen in New York. So what was Behind Monday's record 1100 point sell off for the Dow Jones Industrial Average? Wall Street Journal reporter John Cindreo joins us to help dissect the steep decline and the lingering volatility. So John, we've heard that inflation fears and rising bond yields certainly played a part, but in your story in the Wall Street Journal, you mentioned it also had a lot to do with too much calm among investors.

[John Cindrejo]

Yes, it's one of those. There was this famous American economist called Hyman Minsky who once said that stability brings forth its own instability. It sort of breathes under the surface. It can happen in financial markets as well. And a lot of investors that we talked to seemed to believe this is what happened. They were saying, well, surely there was a bit of a fear that higher bond yields mean that stocks are not as attractive. But actually, we're still very bullish about the economy. We still think things are going well. So we cannot make sense of what's going on in the stock market if it's not because of all the people who are sort of trading a series of products that are linked to volatility, volatility being how much the stock market goes up and down. And there's like a range of investors in the market that are betting on whether volatility will be high or volatility will be low. And because the stock market has been so calm for the last two years, we found that a lot of investors were trying to squeeze some extra return by betting that it would stay calm. And what happens if you do that is that when suddenly it doesn't stay calm for whatever reason, suddenly you lose a lot of money and then you need to offset all those bets that you made that are now losing bets. And it's sort of a reinforcing feedback loop. And this is a bit what we've seen over the last couple of days. And it's interesting because we actually wrote about this before it happened, that it was a possible concern. And it was interesting to actually see it unwind.

[JR Whalen]

And investors are placing bets on volatility on something called the vix. It's a ticker symbol VIX and it's the CBOE Volatility index. Like you said, they have become very complacent. For about two years now, we have seen not a lot of volatility, we've seen a lot of upward trajectory in the markets. And I guess that they took their eye off the fact that gravity eventually is going to take hold at some point.

[John Cindrejo]

In the end, it is a bit like the VIX is basically, it's not a product in itself. You can trade it through different kinds of kinds of products. And several of them have had issues in these last couple of days. It's more like they look at derivatives that are built around these stocks and then they extrapolate a price on whether investors believe that stocks are likely to swing a lot or not in the near future. But in the end it works a bit like, I like to compare it to hurricane insurance. There are some people selling insurance, there's some people buying insurance. Over the long term, you kind of know that the people who sell insurance tend to win because, you know, you don't really insure your house against tornadoes because you want to make money. You do it, you know, to be able to sleep at night. So in the market it's a bit the same. So in theory, you know, betting against this volatility is a good long term strategy and betting for volatility is a bad long term strategy. But what ends up happening is that if you act like an insurer, you'd better be ready for it. And ready means that, well, there comes a day where there is an actual hurricane or a tornado and then you've got to pay out and you need to be able to do it. And this is where a lot of these products and a lot of the investors investing in them get a bit complacent and you know, they might find that they don't have the liquidity to pay and then they have to, you know, offset those bets somewhere else and they end up hurting the broader market.

[JR Whalen]

So they had to say they had to free up some cash in order to cover their bets. Essentially, yes.

[John Cindrejo]

So, you know, let's say that you are selling volatility means that you are sort of betting that the swings in the stock market will be very muted and suddenly you find that, oh, that's a losing bet. What do you do if you're sort of in the jargon, shorting the vix? Well, you Try and buy the vix. And that means that you are sort of betting on more volatility to try and offset the losing bet you made previously. And the thing with that is that there's something that is unlike tornado insurance, which is that in financial markets, the actual insurance can make tornadoes appear or disappear because the different markets are connected underneath. And as I say, when you get hit in one market, you try and buy and sell in the other. So what actually ends up happening is that when a lot of people bet on this VIX going up, they end up making the stock market going up and vice versa.

[JR Whalen]

And the banks had a hand in this also. We're going to discuss that in just a moment. We're speaking with reporter John Cendreo from our London bureau. And you're listening to your Money Matters from the Wall Street Journal. Welcome back, everybody. So, John, in your story in the Wall Street Journal, you mentioned that banks can fuel stock market volatility and it really goes toward them taking sides in bets. Can you just sort of explain that?

[John Cindrejo]

Yes. So before we were explaining how sometimes, you know, people that are actually selling a lot of tornado insurance can make tornadoes disappear for a while. And why is that? Is a big question. Well, at the center of that there is banks. Banks are the ones who actually connect both markets because if you are an investor and you're trying to bet against volatility, then, well, someone else needs to bet for volatility because, you know, it needs, there needs to be two to tango. So these other partners are the banks. On obviously on a net basis, there is investors, you know, that do both things, but on a net basis there's banks on one side who actually are to service their clients. They're forced into, you know, actually buying that insurance and they need to bet that volatility will go up. But banks are not usually in the business of making these kind of bets. They basically are just servicing their clients. So what they do is they offset all these bets that they're having to take in this VIX market in the actual stock market.

[JR Whalen]

We've been down this road before in the sense that we have seen market run ups and we have seen broad gains in the markets and we've seen investors almost be caught off guard and be surprised by volatility and by sharp declines and they have to rush into the market. This is going to happen time and time again. So it starts to make you wonder why investors don't have one hand ready to go to push the right buttons to make sure that they are Ready for volatility?

[John Cindrejo]

Well, there's different kinds of investors, and some investors actually like volatility because it's, it's a chance for them to buy stocks that they might like. But who they, you know, they might think, well, they're too expensive, so I'm going to wait for it to dip. And, you know, the reality of the market is that we like to think about it as this, you know, perfect place where extremely rational people encounter each other and they always make like, the strict rational choice. But reality is that the market has a lot of irrationality to it and it also has a lot of liquidity needs. As I was saying before, like, actually, if you sell insurance against something, you tend to win. Like, that's, that's, it's a good thing to do. So, you know, the market was technically doing the right thing. But that doesn't mean that when the tornado comes and you have to pay out, you've sort of been ready for it because you don't know when the tornado comes. And, you know, it is very hard for markets to be strictly rational because no one can see the future.

[JR Whalen]

Well, we are likely to see uncertainty and storms coming in the future. Maybe not to the degree of what we saw this week, but it's always going to be there and it's important for investors and to be ready. That's Wall Street Journal reporter John Cindrejo joining us from our London bureau. John, thanks for being with us.

[John Cindrejo]

Thank you.

[JR Whalen]

And thank you for listening to your Money Matters. I'm JR Whalen in New York for the Wall Street Journal.

[Announcer]

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