Not Wages. Not Inflation. Volatility. ETFs.

The recent tumble in the market is being attributed to the wage report, a rise in interest rates, and concern about inflation. A reassessment of economic conditions does not lead to such a violent reaction. It might give a push, but then gravity does the rest. For the markets, gravity is the technicals -- how leveraged or overextended investors are, how concentrated, and how much liquidity there is in the face of a flood of selling.

This is just a quick recap of a couple of posts I have done over the past months that relate to technicals behind the current market downturn. In early November I wrote a post about how the low volatility regime we have enjoyed (if that is the right term) could blow up. We have seen the first leg of that with the decimation of the inverse volatility ETFs and ETNs. They have actually printed negative prices. What was worth $2 billion a day ago was worth $20 million in after-hours trading, and depending on how they terminate, could become zero.

The VIX went from the lowest level in history to near the highest. The next shoe that might drop will be the actual market volatility. If actual volatility rises, there will be a rash of funds that target a specified volatility that will have to sell positions -- mostly equities. If a fund is targeting, say, 12% volatility and market volatility goes from 12% to 24%, the fund will need to go from fully invested to 50% invested.

Looking at an extreme tail risk, the total failure of the inverse volatility ETF might cause ripples across ETFs more broadly. Some investors, I would think mostly retail investors, might simply hear that an ETF went to zero in one day, and think that is a concern for other ETFs. If they start to liquidate on that basis, it could lead to widespread contagion. I posit this in a post from October, though with high yield ETFs as the spark.

The cascade due to volatility and the contagion from ETFs might occur, or might not. If they do, it will be a slower process than what we have observed over the past few days. And things do not follow a straight line. There will be "bargain hunting" along the way. But depending on how that plays out, it might be piling more investors onto the thinning ice.