Got some questions about the recent market turmoil?  JP Morgan has some answers:

Is it real or just fear?

Price action two weeks ago seemed driven more by uncertainty and fear, but last week the sell-off was more “real,” with weaker data and less-than-helpful policy actions.

Can the sell-off become self-fulfilling?

The 2008 crisis reminded us of the negative feedback from markets to economies, through capital destruction and a seizing up of lending flows. The fresh memory of that crisis is leading market participants to the same, self-destructive defensive positioning as two years ago, but is also inducing central banks to flood markets with liquidity, to prevent a repeat of 2008. We observe that wealth losses this time around are mostly in equities and very little in fixed income. As a result, bank capital remains intact. With bank capital intact, bank funding largely unmolested, and bank balance sheets much less leveraged, there seems little risk that banks will transmit the market turmoil into a funding crisis for the real economy.

How bad can it get?

If we are right that the underlying cyclical rebound remains in place, that banks will not be a source of contagion, and that policymakers will be generally supportive, then risky markets should bottom over the next month or so. But this argument does not tell us how far the knife can fall.

What assets are most vulnerable in this sell-off?

With our view that investors are largely position-squaring in response to uncertainty, rather than being convinced a double-dip recession is coming, the vulnerable positions are the consensus trades. This is part of why both gold and the dollar suddenly fell last week. Consensus positions (many in our own model portfolio) are still vulnerable, including: cyclicals, small caps, carry-oriented curve steepeners, EM bond longs, HY credit overweights, European bank underweights.

What will stop the sell-off?

Three signals are most important: (1) confirmation that the nonfinancial sector—companies and households—are not panicking and remain in expansion mode; (2) coordination among policymakers to sup- port markets rather than punish them; and (3) markets cease reacting to bad news and start reacting to good news, something that was clearly not present last week. One can understand the frustration of policymakers in the midst of renewed market panic, but the only solution for overstretched public balance sheets is growth, and that requires coordinated support to markets.

What to do in the meanwhile?

Keeping tactical risk low is obvious. Investors with staying power should start buying oversold assets, though, without being in a hurry. Remaining positions should be focused on non-consensus exposures.

Keep risk tight, we’re avoiding consensus trades where feasible, but not giving up on medium-term bullish view on risky assets.

Source: JPM