Daryl Montgomery from The Helicopter Economics Investing Guide has a post up questioning whether a stock market crash could be in the offing. I'm not sure whether crash is right or not but he makes a case for a pullback that will either resonate or not but the idea raises a couple of important talking point.
The S&P 500 has clearly had an awesome rally by any measure in the last 13 months. Some will feel it is fundamentally justified and some not but up seventy whatever percent is a big one. Big rallies after nasty declines is a pattern that has repeated many times in stock market history. While the numbers, on the way down and then back up to this point, may not be in the norm the pattern is normal.
So far in this post I am just talking about market behavior while specifically not discussing the fundamentals.
If you can accept that the pattern (even if not the magnitudes) is normal then you also need to consider what else is normal in the context of large rallies and bull markets (if that is what this is). After big moves, markets correct downward often to the point of scaring the hell out of people. I have felt there would be one more scare the hell out them decline for a while now and have of course been wrong thus far. Be that as it may let this be a reminder of how the market scares people every now and then.
A couple of months ago the market declined a little less than 10% and didn't scare anyone. We can probably conclude that another 9% decline would again not scare anyone, with the context being that enough of a scare would be healthy for the market, so a good cleansing would require more than a 10% decline. Maybe this means 20% or 30% and of course it might not play out that way at all but the occasional scare is a normal thing.
Regardless of whether you are a bull or a bear pullbacks happen and the chance for a "scary" decline is more likely after a big rally that leaves many people feeling pretty good. At various points as the market was going down a lot I commented that a big decline is a lot less likely after a big decline. That sounds quite simplistic of course but it is true. A big rally is also less likely after a big rally.
So here we are today up 70% from the low, volume has been weak for most of it (maybe less participation is part of the new normal if you believe in that theory) and the VIX seems to be expressing some sort of comfort with the current state of the market.
Even if you are wildly bullish a big correction does not have to be disastrous with the Asian Contagion in 1997 and LTCM in 1998 as examples. If you are wildly bearish then you don't believe any of this is real and expect a big decline.
The point here today is one made several times in the past which is to understand/remember that declines are normal and will happen again. As obvious as this sounds many people simply forget or appear to forget about past large declines and go through them like they have never happened before. This was very evident by comments left on this blog and comments left on my posts as they ran on Seeking Alpha along with many other articles by many other people.
In terms of market behavior the only thing that has been different, but not unprecedented, has been the magnitude of the moves. From there people need to then assess the fundamentals to figure out what to do or not do but whatever you conclude about US equities good or bad there will be declines that come along that make us collectively uncomfortable. Losing sight of this is what causes mistakes to be made.
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7 comments:
if you believe in fantasy, nothing to be worried about!
Interesting. HE says that you need frothiness in March/April to have a fall in the Fall. Yet he says that the market is always rallying. I'd think he'd want it to be up/down/up/down.
from a philosophical viewpoint.......greed is what makes the wheels of the world go-around. We tend to believe we are not greedy, but as human beings, we are the most greedy animal.
This is most exemplified in the stock market. Afterall, this is why we are on this blog...trying to keep a step ahead of everyone else.
I certianly don't have another model for world order; but I do hope in the "afterlife", there is a better way!
Now, how can I make enough to be comfortable in retirement!
Roger (and others),
SPX at 1195. 200 DMA is at 1071. 10% correction takes you down to 1076 which is still north of 200 DMA. All is well with the world, "buy the dip".
But a 20-30% decline takes you well south of the 200 DMA, and I guess the operative questions are is that 20-30% decline more likely to be a sharp correction with reversal or a long, drawn out affair, and whether it stops at 30% or is the next 50% decline ala 00-02 and 07-09.
Obviously, none of us have crystal balls...just trying to think through scenarios and most importantly what magnitude of defense/hedging to play on a 200 DMA breach. I've been skeptical of the fundamentals of this rally and current valuation rallies, and view it as almost entirely a technical rally so I'm inclined on a 200 DMA breach to mimic Hussman and fully hedge all equity exposure. Just curious if you are inclined or seriously considering a greater level of defensive action on any 200 DMA breach relative to the magnitude of defense you played in 07-08.
Just trying to figure out how to potentially capture as much of any rally and avoid any sizable drawdowns otherwise as Hussman points out this week you are essentially just going on an interesting ride to nowhere.
FWIW, the relevant excerpts:
http://www.hussman.net/wmc/wmc100412.htm
"As a result, investors have earned an average annual total return of just 2.4% in the S&P 500 over the past 12 years, while enduring two separate instances where they have lost about half of their money as part of the ride. Essentially, we have gone nowhere in an interesting way. At present, investors have priced the market at a level that makes a continuation of this experience likely for several years to come.
So to whatever degree one has participated in this 13-month, 70%, top 1% market rally:
http://www.ritholtz.com/blog/2010/04/rally-rank-27-of-4237/
It is just a paper value at the moment that could easily evaporate if the next 50% decline is somewhere off on the horizon, perhaps well out of sight at the moment.
FWIW, for those looking to add to their toolboxes, here is another interesting technical metric that may aid in deciding when to play defense:
5% below the 50 DMA
http://www.contraryinvestor.com/2010archives/momar10.htm
200DMA as trigger for hedging worked ok since 2000. Backtest it over prior periods and results are less appealing. Mid-70's thru 1980 for example. It's good to keep track of the 200DMA, just resist the temptation to go all-in or out around it.
I'll ruthlessly close a trade if its going against me -- sell discipline has to be at least as strong as buy discipline -- and don't have any problem selling winners too based on whichever upper bound I have decided is appropriate (the nature of the buy decision usually determines the nature of the technical, fundamental and/or quantitative target).
But the decision to take profits is often not trivial because even though no one ever went broke doing so (as the old saying goes) it's not as easy gaining wealth if you take profits too soon particularly when you add the offset of trades that didn't do as well; e.g., selling 1/2 of a position at a price double to pay for the whole play sounds fine considered in isolation.
The kicker being the question of whether the risk/reward ratio has changed. If it has then that alone can trigger a decision even if the asset is still rising in price: My own rule of thumb is that I expect to make 5-times as much from an asset as I think I can lose; if the ratio falls below that I look for a replacement. FWIW
As a kind of weird side-note, the big runup since March has handed me more 10-baggers than I've had since 1999, but a couple of them passed their targets with such authority I let them run and now can't seem to muster the gumption to liquidate them. Damnedest thing: Makes me return to the notion that discipline is a more reliable ally than profit.
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