A second market sell-off could be ‘Lehman-like’

Investors shouldn’t take much solace from Tuesday’s slight rebound from the worst day of the year because the next sell-off could be even more violent, something resembling a crisis-level plunge triggered by the collapse of Lehman Brothers, according to Nomura.

This view is much more catastrophic than the rest of Wall Street with most firms predicting a stock market correction (down 10%) at most and likely just a slight pullback. Nomura is basing its view on data showing hedge funds fleeing the market and said more are set to exit when their algorithms are triggered by rising volatility.

Stocks are set to rebound from their worst day of the year on Tuesday as China stabilized the yuan, which many believed was used as a weapon in the trade war with the U.S. The Dow Jones Industrial Average dived 767 points on Monday, its sixth largest point drop in history, after China allowed its currency to breach a psychological level and also halted purchase of U.S. farm goods. The Cboe Volatility Index, AKA Wall Street’s “fear gauge,” swung to the highest in 2019 on Monday.

“At this point, we think it would be a mistake to dismiss the possibility of a Lehman-like shock as a mere tail risk,” Nomura macro and quant strategist Masanari Takada said in a note on Tuesday. “The pattern in US stock market sentiment has come to even more closely resemble the picture of sentiment on the eve of the 2008 Lehman Brothers collapse that marked the onset of the global financial crisis.”

Nomura’s propriety sentiment data, which incorporates a slew of macro and quantitative data, are showing a “deterioration in supply demand for equities and a sharp downward break in fundamentals,” the analyst pointed out. In other words, it shows hedge funds and other key players are bailing on the market and in some cases betting on a big drop. The recent trend has been closing tracking the scary times in 2007 and 2008, leading Nomura to predict increasing chances of a second sell-off as brutal as the one in Sept. 2008 when Lehman Brothers’ bankruptcy filing catalyzed the Great Financial Crisis.

Takada’s data anticipated a spike in volatility before Monday’s plunge. A few big options traders were also betting on a decline through wagers on increased volatility. (The VIX spikes when the market drops.) The bets started to pay off after the Federal Reserve failed to signal more rate cuts jolted market volatility earlier in the week. But the chaos soon intensified after President Donald Trump surprisingly ended the ceasefire with China and slapped additional tariffs, sending the VIX even higher.

Nomura is making a technical case for a sell-off but not many see a fundamental case for a return to the financial crisis. However, former Treasury Secretary Larry Summers said Tuesday the ongoing trade dispute between the U.S. and China is potentially creating “the most dangerous financial moment” since the global crash at the end of the last decade.

The market plunge could arrive as soon as late August, Nomura predicted, as trend-following algo traders still have many bullish trades to unwind.

“We would expect any near-term rally to be no more than a head fake, and think that any such rally would be best treated as an opportunity to sell in preparation for the second wave of volatility that we expect will arrive in late August or early September,” Takada said. “We would add here that the second wave may well hit harder than the first, like an aftershock that eclipses the initial earthquake.”

— CNBC’s Michael Bloom contributed reporting.