The Market's Mechanism Is Broken For Now

"Fubar. Ya'll got that right."

-- Saving Private Ryan

The market's mechanism is broken for now, with an important assist from volatility-trending and risk-parity strategies that allocate based on price and volatility rather than any intrinsic sense of value. Put simply, the quants have ruined our markets by exaggerating short-term price moves -- and many market participants either underestimate or don't understand the quants' disruptive impact.

However, retail investors have responded to the market's unpredictability by taking money out of U.S. equity funds, while institutional players have grown more inactive (and more frustrated). This has created a "volume void" that the aforementioned quant strategies have exploited.

Here's a chart that shows the recent unwind of short volatility trades, which are principally executed by quant funds. Note that the trading volume in volatility ETFs has spiked:

Source: Bloomberg and @sentimentrader via The Daily Shot

All I can say is: "Fubar!"

Pay Attention to Bond Yields

The bond market has been another, more fundamental factor that's contributed to stocks' recent downturn and increased volatility.

U.S. and foreign bond prices have been stretched in a speculative orgy or buying by central banks and others -- so much so that I suggested back in July that we'd likely hit a generational low in yields.

I suspect that the 10-year U.S. Treasury yield's reversal over the past week out of its recent 1.5%-1.6% band is partly responsible for stocks' recent weakness. After all, the correlation between stocks and bonds has been clear since early this year. Here's a chart of the 30-year Treasury yield:

Source: The Daily Shot

That said, the value of owning global fixed income as a hedge against stocks is subject to debate these days, as markets have begun to question the negative Treasury term premium:

Source: New York Fed via The Daily Shot

Always remember that stock prices ultimately key off of the risk free rate of return -- i.e., the 10-year Treasury yield, which is now rising. So, history tells us that stock valuations should contract as interest rates rise.

This effect is only being exacerbated by a weak real global economy, in which central bankers have lost their effectiveness as fiscal inertia thrives (especially in Washington, D.C.).

The Bottom Line

Two of the most important reasons that I see for the market indigestion that began last Friday are the global bond market's speculative unwind and the disproportionate role of volatility-trending and risk-parity quant strategies in stocks.

I personally believe that this indigestion and the associated volatility will likely continue over the next few months, so I'm starting the day at about a market-neutral position. I've also substantially reduced my value at risk (or "VAR").

I plan to emphasize opportunistic trading rather than buy-and-hold strategies over 2016's balance -- although that's not to say that I won't have my eye on positioning for longer-term investing opportunities as they arise.