The S&P 500 index hit a high of 2,130.82 on May 21. In market terms a “correction” is defined as a decline of 10% or more from the most recent high. Last Thursday the index declined by 2.11%. Friday it fell by another 3.19% to close at 1,970. This morning, following significant selling in the Asian markets, the index opened at 1,965, and swiftly traded to an intraday low of 1,867. The Dow Jones Industrial Average (DJII) was briefly down over 1,000 at this morning’s low.

The markets recovered almost 80% of the mornings’ drop, only to fall again by the close. The drop of 3.94% today, with a close on the S&P 500 of 1,893.21 means that we have surpassed the 10% drop that defines a correction.

Investors in the securities markets are reacting to something that is not yet entirely clear. Headlines attribute the past few days’ decline to a combination of slowing growth and a stock market rout in China. That’s the only plausible thought the media can tease out of the market mavens they have talked with. They confirm these suspicions by pointing to the decline in prices of commodities. China has been facing slowing growth for years. Only recently has the “slowing” narrative morphed into fears of a “collapse.” In an oxymoronic twist on Tuesday, the news outlets were pointing to a rebound in China’s housing data as evidence of significant outflows from the stock markets. Further, many analysts say that we cannot trust the economic data from China due to manipulation by their government. This is also nothing new; it just seems that these complaints have gotten louder. So why have we seen such a severe reaction in the last three days? Why now and not months ago?

Alongside the Chinese market declines, the “Beijing Put” seems to be losing its effectiveness. The Chinese government has stepped in and implemented various stimulus measures, not least of which was the devaluation of the yuan. Yet the Chinese stock market continues to fall in spite of these measures, and as a result, the word “desperate” has begun to enter the China narrative.

Chinese stock markets have certainly faced volatility in the past few months, with the Shanghai Composite now down a shocking 38% from its June 12 high. But the market commentators seem to have forgotten all about the dramatic 60% rise the index experienced in the first half of the year. After what feels like a grueling stock market rout in China, the Shanghai composite is only down a paltry 0.77% year to date. In fact, the U.S. stock market has now fallen more than the Chinese stock market in 2015. It seems as though the headlines focus on the bad, and quickly forget the good. This, combined with increased usage of the words “collapse” and “desperate,” contributes to an overall feeling of panic and hyperbole that is difficult to shake when there isn’t any actual news.

There has been very little coverage about the changes that have evolved since the 2008 crisis in the way the U.S. stock markets operate. Before the crisis, a significant majority (over 70%) of the volume was traded on the exchange. Now, with the evolution of electronic exchanges, dark pools and high-frequency trading, the exchanges’ percent of total volume is as low as 20%. This has resulted in a sharp drop in trading costs, and some significant liquidity issues. Before, specialists used to facilitate trading to help make markets smoother. They committed capital and their return on that capital was earned on the bid/ask spread. As those bid/ask spreads have come down with the increasing popularity of electronic trading, there is less of an incentive for specialists to commit capital. With less capital available to market participants, liquidity tends to dry up during a spell of volatility (as we saw this morning), which only fuels more volatility.

In summary, we think there are two main drivers to the dramatic sell-off the market has experienced over the last few trading sessions. 1) A momentum shift in sentiment as it relates to China and its economy towards panic, 2) reduced market liquidity and the news “vacuum” typical of late August. Each of these has been exacerbated by the reduction in capital commitment by Wall Street to stock trading.

When faced with periods of heightened volatility, we are left to determine what action to take in our client portfolios. The dramatic move the last few trading days can be surprising, but actions we have taken in our portfolios this year anticipated weakness in foreign economies. We took steps earlier this year to increase our portfolio’s exposure to U.S. revenues to insulate our portfolio from foreign market weakness. We reduced our exposure in the Energy Sector, which has continued to struggle with excess supply and possible weakness in Chinese demand. Our portfolios have still participated in the market’s decline, but these actions have allowed for better relative performance.

The U.S economy continues to be in solid shape as indicated both by the last week’s housing data and the desire of the FOMC to raise interest rates in response to improving economic fundamentals. We believe the selloff will prove to be a buying opportunity, but we will be patient in finding an entry point while we and other market participants gather data to improve our clarity.

Individual investment positions detailed in this post should not be construed as a recommendation to purchase or sell the security. Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Employees and/or owners of Nelson Roberts Investment Advisors, LLC may have a position securities mentioned in this post. Please contact us for a complete list of portfolio holdings. For additional information please contact us at 650-322-4000.