Michael Burry laid out fears of a harrowing scenario for US stocks driven by something that he says not many are looking out for
“The Big Short” investor, famed for his bet against the US housing market ahead of the 2008 crash, wrote in his most recent post on Substack that he sees the risk of a rapid unwind in stocks thanks to a wave of automated selling by volatility-focused investment funds
The result could be “carnage” for stocks caught in the unwind, Burry said
He pointed to the recent plunge in momentum stocks as an example of how such a scenario could unfold. Momentum stocks, which are those that have seen a rapid increase in their price, have cratered in recent weeks as investors take profits and rotate out of high-flying memory makers and chip names. The iShares MSCI USA Momentum Factor ETF is down 14% from its recent peak
“That leaves a bloody mess, but most would not be looking for it,” Burry warned
Automated volatility-focused funds on Wall Street pose a problem in today’s market, which is more volatile than it has been in the past, Burry said
In particular, stocks appear to be more reactive on down days. The measure of “extra fear” in markets — or, the “asymmetric and out-of-proportion severity” of the market’s reaction on a down day — has climbed to its highest level in 98 years, Burry said
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On the flip side, markets are also much faster to recover after experiencing bouts of chaotic selling — a sign that automated trading programs are stoking much of the volatility, he added
“The data suggest the investor today is more likely to get upset at a smaller loss relative to a larger one, more likely to buy the dip intraday, and more likely to be experiencing severe chaos,” Burry wrote. “In case one is wondering, no, there is no human investor that works like that.”
Burry laid out several scenarios where volatility-focused funds could stoke large, sudden drawdowns in stocks, given how leveraged some funds are. He outlined a hypothetical where the S&P 500 could see a mild 2.5% drawdown, prompting volatility funds to cut their exposure from 77% to around 50% of their assets, illustrating the potential for much greater downside
Volatility-targeting funds have around $500 billion in assets under management, Burry said, citing his analysis of S&P 500 futures contracts
That sounds like a drop in the bucket compared to the broader $60 trillion US stock market, but it could still represent a sizable hit to the market if the selling from automated programs happens all at once, Burry said
The losses could be compounded if passive investors, who keep the market relatively stable, begin to sell stock as well, he added
“That is massive and unleashes all kinds of momentum into the market that is picked up by other players,” Burry wrote of a potential unwind
“That selling can trigger any number of stop losses or risk management strategies,” he said, later adding that the market would recover “much faster than it used to,” per the historical norm so far this decade
Burry, who’s been bearish on popular trades in chips and AI stocks recently, has repeatedly pointed to the risks he sees building for the bull market, particularly as more investors grow wary about the sustainability of the AI trade
Recently, he flagged threats that he said could be lurking in the private credit sector, as well as circular deals in the artificial intelligence space, specifically those tied to Nvidia
