What a wild week in equity markets it was. Markets took the escalator up over the last five months and took the elevator down for a week into correction territory. In a world where 85% of the daily volume on stock exchanges are from computer algorithms that do not have logic or common sense, wild things can happen when they continue to push the sell button and buyers go on strike at the same time. Between the extremely high sentiment readings, the possibility for a “Bernie” Socialist presidential candidate being the nominee for the Democratic Party, the fear over the coronavirus and the inevitable corporate guide-downs coming because of it, fear and panic was in the air and stocks took a nosedive. In my opinion it’s not nearly as important to try and figure out the WHY as it is being focused on the WHATS NEXT. It is important though to remind people what has historically happened to stocks during and after viruses and pandemics were discovered: Catalyst Blog: History of Pandemics on Stocks
What we currently have is fear, uncertainty, and doubt. The irony, we had euphoria, certainty, and arrogance just a week or 10 days ago. Everything moves at warp speed these days. Just a week ago, the equity market went to all-time highs, the number of bulls was high, bears were quiet and speculative options buying was at levels typically associated with periods of poor short-term equity returns. In a matter of a week, all these conditions have reversed and now bulls are back on their heels, a much more attractive place from a forward equity returns perspective. For this week’s blog, I’ll focus on the historical data that could serve as a hint to what might come next and for the rest of the year.
The speed of this downdraft has truly been historic.
I think we all remember December 2018; it was an unpleasant month until the 24th of December when stocks bottomed. Stocks pretty much went straight down from September 30, 2018 until December 24, 2018 but there was no two-day period with such wicked selling like we just experienced. Historic readings are what we call three standard deviation events and they rarely continue at the same trajectory. It’s important to slow things down and take a deep breath. Clearly the drawdowns did not feel good, but I think it’s important to understand just how rare they have historically happened. This wreaks of institutional allocators called CTA’s systematically moving out of “beta” or the stock market, the ETF effect of massive selling pushing down good and bad stocks and allocators rotating away from companies that could be affected by the slowdown and going into stocks that appear more immune. Essentially high beta was sold, cash and bonds caught a bid, volatility was purchased, and defensive equities were in high demand. That’s the risk-on, risk-off playbook for investors. Here’s a great quote (below) from Sentimentrader on February 25th. I’ll fade the fear for now.
I’ve been investing in great brands for over 25 years and in my experience, making money in the stock market is ~60% sentiment, 20% fundamentals and 10% luck. Whether we like it or not the stock, bond, and options market are just highly sophisticated casino’s where bulls and bears duke it out daily. When there are more buyers than sellers, prices go higher, when there are more sellers, prices go lower. Sentiment largely drives much of this price behavior and at sentiment extremes, there’s usually an opportunity to fade the extreme, even if for only a short period of time.
Right now, fear, uncertainty and doubt are ruling the day and stocks are in the process of re-pricing for a world with more uncertainty, slower growth, lower rates, persistent accommodations & liquidity injections by all global central banks, political volatility, and higher volatility with short periods of spasmic price action. This world favors more nimble and active management, the ability to use cash as an asset class, and a focus on high-conviction strategies versus owning thousands of companies.
Here’s the rub: the typical equity portfolio holds 1,000+ stocks across the funds and ETF’s that are owned. An ETF-only portfolio likely owns >3000 stocks given the indexes hold more stocks than the average active fund. In an uncertain environment, less companies thrive so less companies should perform well. That’s not my opinion that’s just logic. I urge you to review your current equity allocation and make sure you have sufficient exposure to more concentrated and flexible strategies. As always, I am happy to do a full analysis of your portfolio to show you what the statics are. I’ve done a number of these already and the result was the realization of a portfolio that needed some tweaking and risk management additions.
Two Standard Deviation Moves are Rare
Storms can be fierce but they rarely last very long. The same can be said where markets are concerned. Over the last week, the equity markets and volatility have witnessed three standard deviation events, moving wildly in a very short period. Three standard deviation events are like Category 5 hurricanes. Given how rare these events are, they should not be expected to continue indefinitely. The image below shows two standard deviation events (three standard deviation events are so rare there’s just a few instances to show) like we just experienced. What’s the moral of the story? There have been two times since 1945 where we saw similar back to back large losses when the S&P 500 saw a multi-year high within the past week. There were five more times when we saw two plus standard deviation moves of similar magnitude over short periods of time for a total of seven incidences. Now we have eight occurrences.
What happened going forward? From one month to one year, the odds of positive gains were high most of the time with a median return of +18% and 80% of the time the one-year return was a positive number. Those are pretty good odds to roll into Vegas with an understanding that there are no sure things!
Here are some bottom-line takeaway points to consider:
- Right now, we are being bombarded with multiple scary headlines. Caution is warranted.
- When uncertainty arrives, markets get more volatile. We expect volatility to stick around for the near term.
- Volatility is the friend of long- term investors and offers the opportunity to buy great assets on sale.
- Be greedy when people are fearful and be fearful when they are greedy. Hurricanes do not last for long and when extremes happen, the odds favor the fading of those extremes.
This information was produced by and the opinions expressed are those of the author as of the date of writing and are subject to change. Any research is based on the author’s proprietary research and analysis of global markets and investing. The information and/or analysis presented have been compiled or arrived at from sources believed to be reliable, however the author does not make any representation as their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated therein. There are no material changes to the conditions, objectives or investment strategies of the model portfolios for the period portrayed. Any sectors or allocations referenced may or may not be represented in portfolios managed by the author, and do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that any investments in sectors and markets identified or described were or will be profitable. Investing entails risks, including possible loss of principal. The use of tools cannot guarantee performance. The charts depicted within this presentation are for illustrative purposes only and are not indicative of future performance. Past performance is no guarantee of future results.