1987 All Over Again?

By datatrekresearch in Blog

As tempting as it is to call a bottom for the current flush in US equities, we will hold off for one reason, even if it is an outlier probability: markets crash when they are already oversold. That might seem counterintuitive, but consider the following daily return series around the October 1987 crash for the S&P 500:

The three days before:

• October 14: -2.95%
• October 15: -2.34%
• October 16: -5.16%

The day of the crash:

• October 19: -20.47%

The three days after the crash:

• October 20: +5.33%
• October 21: +9.10%
• October 22: -3.92%

You can see the problem: the net price return over this time series is negative 21.1%, even with the two bounce back days. Moreover, the S&P price return for October 22 through the rest of the year was negative 0.5%. So while 1987 did show a positive total return of 5.8%, buying in the aftermath of the crash didn’t help performance.

To be clear: we are not calling for a crash, but it is our job to help you consider risk management during periods of market stress and October 1987 is one example of why that’s important. We’ve seen too many other market commentators try to pick a bottom in the last few days, obviously to no avail. We were trading at SAC during the post-dot com bubble implosion, so we know those calls are simply shots in the dark. And we sat on a large agency brokerage desk in 2008, watching the world try to bottom pick that market. The results were the same as in 2000. Not good.

What we think is more useful: a roadmap through the minefield. The old market cliché that “bottoming is a process, not an event” is true. Here are the waypoints we think are important:

#1. Sentiment on Fed Funds hikes. The current rout in global equities is the market’s way of telling the Federal Reserve they are on the wrong course. Instead of lectures about an overheating economy (Bostic yesterday) or the neutral rate (Kaplan today), markets want to hear the Fed recognize global risks to growth and their potential effect on the US economy in 2019.

• One number to watch: the odds of a Fed rate hike in December. These declined dramatically today, to 66% from 81% yesterday.

#2. Performance differential between US large cap Technology and Consumer Staples stocks. This is fast becoming one of our go-to indicators for market stress since we wrote about it (and recommended Staples) Sunday night. It essentially measures market stress by comparing the daily returns of the largest defensive sector (Staples) versus the riskiest group (Tech).

• Based on a short-term (90 trading days) reading, Tech must still decline further relative to Staples. That means the market can still head lower, because Tech’s weighting in the S&P 500 is 20% and Staples are just 7%. [su_spacer] The numbers here: Through today’s close Staples have outperformed Tech by 7.0 percentage points over the last 90 days. The standard deviation of this time series back to 1998 is 10, with a mean reading of 0.2 in favor of Tech. [su_spacer] Bottom line: Staples still need to outperform by 3 more percentage points versus Tech before any shift to defensive stocks signals unusual risk aversion.

#3. The CBOE VIX Index. Yes, this is an over-referenced tool but in times of stress it is a useful one.

• We closed today at 25, which is still below the 26-27 levels from 2 weeks ago. That’s not good, considering today’s decline. A real bottom would have a higher VIX. [su_spacer] The numbers to watch for: 28, which is one standard deviation from the long run mean. The next stop is 36, which is 2 standard deviations.

#4. Non US equities. The MSCI Emerging Markets Index is down 18.6% YTD; EAFE is 13.1% lower. US stocks are still better – and they should be – but international markets are flashing yellow and domestic stocks are slowing to a stop.

• The one market to watch: Shanghai, down 21% YTD. Stabilization here will signal that the Chinese economy isn’t about to experience a sharp slowdown.

Summing up: we don’t think the selling is over and now is not the time to bottom feed. Watch our signals (we’ll keep you updated), but stay defensive.