The big market drop could be a correction, not a contagion

(Fortune) -- For stock market operators, a strong stomach and preparedness for the unknowable are critical traits. Yesterday's action in the U.S. equity markets tested even the most savvy of investors. But, as Robert Frost famously said, "In three words I can sum up everything I've learned about life: it goes on." And indeed it does.

While the intraday move is quickly being dismissed by punditry as a "fat finger," or human error -- and to some extent that may be accurate -- it is critical to remember that markets are interconnected. The current catch phrase in stock market parlance is "contagion." A contagion in medical terms is a contagious disease, and in this scenario implies that the whole world is going to catch the Greek sovereign debt flu.

Esteemed investor George Soros had a more apt description for contagion. He calls it "reflexivity." Specifically, market events aren't random: they are influenced by other events. Taken a step further, actual fundamentals are influenced by market events, so the market and prices in effect are leading indicators for fundamentals.

The MAWG effect

Thursday afternoon's chaos was likely an isolated event. Some Middle Aged White Guy, or MAWG, on a trading desk at a major financial institution ran the wrong algorithm or sold shares when he should have been buying, albeit on a massive scale. But the reality is that this event, which was the largest intraday drop for the Dow in stock market history, occurred on a day and in a period when the market and investors were incredibly skittish and schizophrenic due to accelerating sovereign debt issues. Even if this was a simple error, the timing seemed far from random.

In fact, this event is likely a catalyst for more market volatility in the coming weeks, rather than a return to complacency and the upward trend in the market. This view is based on signals from a number of the key factors that we monitor in our risk management models, which include: credit spreads, volatility, and sovereign debt credit default swaps. These factors have been signaling to us the potential for an equity market correction, and continue to signal further turbulence ahead.

Credit spreads widening in conjunction with a declining stock market typically indicated a dramatic shift away from any type of risk by institutional investors. More specifically, they also signal bond investors getting increasingly concerned about fundamentals and cash flow. Over the course of the past few days, corporate high-yield yields widened dramatically from 8.2% to 8.6%. This morning, yields continued to climb.

The fear index

The VIX is one of a few measures of volatility that we use, and it has been accurately called the fear index. As investors get scared and sell assets, volatility spikes, which increases the potential intraday moves of asset classes. Similar to credit spreads, equity volatility had been increasing over the past few weeks and is up another 14% this morning, signaling increasing fear and volatility ahead.

The rational and irrational in the markets

On the final point, credit default swap spreads widened for many European countries over night. In fact, many are approaching all time highs. Greece's five-year CDS rose 10, to 950 basis points, while those of Portugal rose 60, to 495 basis points, and Spanish CDS rose 17, to 290 basis points. If this data tells us anything, it is that any proposed EU bailout that is on the table is insufficient, and there are more European sovereign debt issues looming ahead of us.

While we support the adage that the time to buy is when there is blood in the street, that strategy needs to be framed with the understanding that equity markets can stay irrational, and usually do, for longer than investors expect. In early 2009, very few investors predicted that the market would climb over 75% in the ensuing 15-months. Conversely, the correction, when it occurs, will likely be of longer duration than the consensus group thinkers believe as well. And the correction is perhaps only beginning.

--Daryl G. Jones is Managing Director at Hedgeye Risk Management.