Among the many theories explaining why U.S. stock markets slumped at the start of October, blaming the bond market stood out. After all, the Federal Reserve’s loose monetary policy supported asset prices for nearly a decade, and now its swollen balance sheet is a logical bugaboo for stocks.
This is what played out last week. Bond yields continued their march higher as investors decided Fed chair Jerome Powell isn’t kidding about his plan to hike interest rates to match the strong economy. As yields on the 10-year Treasury hit nearly 3.25% and mortgage rates zipped to 5%, stock markets plunged. Given these moves, it’s easy to assume the bond market will kill the stock market. Put differently, interest rates moving off Fed-induced record lows will take the air out of stocks priced at record highs.
Bill Miller of Miller Value Partners put it this way in his third-quarter letter to investors: “The most important thing that happened to the stock market this quarter is what happened to the bond market.”
As Miller notes, 4% GDP growth, 50-year lows in unemployment and nascent wage inflation has the Fed stating it is a long way from neutral interest rates. When rates began moving, Miller points out, the bear case for stocks shifted from talk of an inverted yield curve, implying a looming recession, to one where the steepening of the yield curve revealed inflation worries.
To all of this speculation, Miller threw his hands in the air, admitting he’s not much of a forecaster. “It’s a bull market in stocks and it will continue until it ends, and no one knows when that will be. It will end when either the economy turns down and earnings decline, or when interest rates rise to a level where bond yields provide significant competition for stocks,” Miller said.
He won’t predict when, or how, the stock market’s bull run will end, but Miller nonetheless made an elegant case for equities, which is worth holding onto during selloffs.
Some believe a 3.5% yield on the 10-year treasury will be the tipping point when investors decide they are earning enough from risk free assets to pull money from the riskier stock market. Miller is skeptical. As he points out, a 3.5% yield effectively has investors holding their money in an asset priced at 30-times a return stream that won’t grow. This compares to stocks, trading at 17-times next year’s earnings, with the prospect of steady 5% growth.
“Valuations of stocks do not appear demanding compared to returns available in other asset classes,” Miller points out. Comparing bond yields to the earnings yield on stocks is charitable, but the point is well taken. Until recently, stocks were priced at about the same dividend yield as the income afforded by government bonds, forgetting the equity upside. “[P]eople will begin to notice that bond returns in the past 5 years have been the lowest ever recorded and that is likely to only get worse if inflation continues its upward trajectory,” Miller rightly points out.
As he told Forbes for a feature we ran last year, investors shell-shocked by the financial crisis are still “risk and volatility phobic” and have created a “safety bubble.” Miller says he continues to find opportunity in stocks.
A way to test this optimistic market math is Apple. It’s the largest holding in most retirement accounts due to its cap weight in the S&P 500 Index and a top position for Miller’s strong-performing $2.4 billion Opportunity Equity fund. On income streams alone, would one rather own Apple, now trading a bit below the S&P 500’s price of 22-times earnings and owning a dividend yield of 1.3%, or bonds?
In recent years, the smart money took Apple.
Warren Buffett began buying Apple in early 2016. Where does he now stand? His $145 a share basis, per FactSet data, means Berkshire’s $54 billion holding came at a price of ten-times expected 2018 free cash flow and dividend yield of 2.4% based on 2019 estimates (1.9% for 2018). Based on income, Apple remains in the running with today’s surging bond yields. The kicker is Apple stock has gained about 50% from Berkshire’s cost basis.
Bottom Line: The risk/reward of the market’s biggest stock plays right into Miller’s “safety bubble” theory. For all of the equity upside of Apple, investors in a 3.5% bond market are still only giving up about a percentage point annually of yield. It’s the trade-off investors should remind themselves of next time a bond market scare takes the steam out of stocks.
“What the bulls need right now more than anything else is for the Federal Reserve to be proven wrong,” Cramer said Monday evening on “Mad Money” after stocks continued last week’s decline and before the rally at Tuesday’s open.
Cramer has been railing against what he calls “the Fed-mandated slowdown” since last week’s market meltdown, arguing Powell needs to recognize the signals of a slowing economy and stop raising interest rates.
Growth may look strong now, with inflation creeping up, but it won’t remain that way in 2019, Cramer said. “The bull thesis is very simple. You have to bet the Fed tightens in December and then says, ‘You know what? We may be winning the battle against inflation. So let’s wait and see what happens rather than committing to three more rate hikes [next year].'”
“If they do that, you know what’s going to happen? We are going to get a huge rally into the end of the year,” predicted Cramer, while also warning that the Fed does not have a good track record of making the right moves in the face of slowing growth.
Stressing the “current situation is nothing like 2007 where we just had gigantic systemic risk,” Cramer said Monday, “I think we’re looking at a small Fed-mandated slowdown, not a total financial meltdown.”
“But it sure feels like the Fed is making the exact same mistakes, doesn’t it?” he asked, rhetorically, referring to what he believes is the current Fed’s failure to take off its blinders.
Cramer implored Powell to listen to the buzz on trading floors and from Wall Street research firms about being “late in the cycle,” explaining that’s code for “‘it’s about as good as it gets;’ we’re decelerating, may be quickly.”
On Monday’s show, Cramer reiterated that Powell needs to change course and make monetary policy data-dependent again, rather than sticking with his comments early this month that rates are a “long way” from neutral.
Those remarks, coupled with projections after the September Fed meeting, about an aggressive path higher for rates next year, put pressure on stocks that resulted in last week’s 4 percent plunge.
The Fed has hiked rates three times this year, with another one expected in December.
A strong batch of quarterly profit reports from a trio of stocks in the Dow Jones industrial average sparked a market rebound Tuesday on Wall Street.
The better-than-expected third-quarter results from companies in the health care and financial services businesses eased fears of an economic slowdown as interest rates move higher.
The Dow was higher by 400 points, or 1.6 percent, to 25,652 in afternoon trading Tuesday. That rise, which puts it on track for its best one-day point gain since early March, helped it recoup a small chunk of its nearly 1,600-point drop after declines in six of the previous eight trading sessions.
Third-quarter results from drug maker Johnson & Johnson, health insurer UnitedHealth Group and Wall Street bank Goldman Sachs pushed stock prices up broadly Tuesday.
The good news on profits, coupled with upbeat data on home-builder confidence, job openings and the nation’s industrial sector, reinforced optimists’ belief that the economy remains strong in the face of rising borrowing costs and the fallout from trade tensions between the U.S. and China.
“I think solid earnings will stabilize the market,” says Nick Sargen, Fort Washington Investment Advisors in Cincinnati.
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While it’s still early in the earnings reporting season, profits for all the companies in the Standard & Poor’s 500 stock index are expected to grow nearly 22 percent, putting profits on track for a third straight quarter of 20 percent-plus growth, according to earnings tracker Refinitiv.
Heading into Tuesday, the broad stock market, as measured by the Standard & Poor’s 500, was 6.1 percent below its September all-time high.
Looking ahead, Sargen views the recent stock market weakness as a short-term price adjustment, not the start of a serious downturn that could lead to a bear market, or 20 percent drop from last month’s record high.
“What happened this month is a correction, not a bear market,” says Sargen. “That said, it may be a preview of coming attractions for next year.”
Finding winners during the recent stock market slump was tough.
Only two dozen, or less than five percent, of the 500 companies in the Standard & Poor’s 500 stock index have gone up in the past five trading days, according to Bloomberg data. During this downbeat stretch on Wall Street, the broad market gauge has tumbled 4.6 percent, its biggest sell-off in seven months.
But a few bright spots have emerged in an otherwise battered market, which has been undone by fears ranging from a spike in U.S. borrowing costs to continued trade tensions with China. Investors fear that these twin risks will cause a slowdown in the U.S. economy and corporate profits, both of which have been firing on all cylinders this year and are a big reason why the S&P 500 notched a record high in late September.
Not surprisingly, the best places to shield cash from the storm are the “defensive” parts of the market. The stocks that have held up best are companies that sell everyday consumer products or provide services that stay in demand whether the economy is booming or contracting. In contrast, high-fliers, including many popular tech stocks like chip maker Nvidia, have suffered steep drops.
“The selling really has been across the board,” says Ari Wald, head of technical analysis at Oppenheimer. “But (less aggressive stocks) have held up a bit better.”
Some of the well-known companies that have shielded investors from losses in the market downturn include:
The discount retailer known for its long list of products like toothpaste and toilet paper that sell for about a buck, eked out a gain of 1 percent. Similarly, low-price, member-driven retailer Costco rose 0.26 percent.
This company, best known for food brands that are staples in Americans’ freezers, refrigerators and pantries, including Healthy Choice, Reddi Wip and Orville Redenbacher, has rallied 4 percent.
Walgreens Boots Alliance:
The drug store chain, which handles everything from medical prescriptions to sales of everyday items like water, cosmetics and shampoo, has risen 0.8 percent.
Electric and gas utilities like PSE&G:
These kinds of companies also avoided losing a lot of money, since investors know people need to turn on the lights, and run washers and dryers at home no matter how turbulent markets are. Shares of the Newark, N.J.-based utility are virtually unchanged since the market swoon began on Oct. 10.
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Another area of the market that has provided cover is gold, a metal that has historically been viewed as a haven when markets turn rocky. Last week, for example, when the stock market was in free fall, shares of gold stocks rose nearly 5 percent, according to S&P Dow Jones Indices. And gold has jumped 3.6 percent in the past five trading sessions to nearly $1,231 per ounce.
These types of investments could continue to fare well if the stock pullback continues.
“A rotation into areas where demand will remain relatively stable will remain of greatest interest to investors that are beginning to question the health of the economy and the trajectory of corporate earnings,” says Sam Stovall, chief investment strategist of U.S. Equity Strategy at CFRA.
However, if the market regains its footing quickly, there’s a good chance that many of the former market leaders that got hit the worst in the sell-off could rebound. That’s because investors could return to companies whose business outlooks haven’t necessarily changed, adds Stovall.
Twitter, a social media company, for example, is up nearly 0.6 percent in the past five sessions, despite an 8.5 percent slide last Wednesday.
“Stocks that get beaten up the most are often the ones investors jump right back into,” Stovall says.
Investors bruised by recent punishing losses in stocks have something to look forward to: corporate earnings.
The benchmark S&P 500 index has risen in seven of the past nine earnings seasons, climbing on average 1.7% during the four weeks after big banks kick off the reporting period, according to Dow Jones Market Data.
Even more encouraging is that in three of those periods, the S&P 500 had fallen in the four weeks leading up to earnings season. In other words, it isn’t unusual for the equity market to go through a period of weakness before corporations report earnings.
That is one reason some analysts remain confident that solid company results can power the stock market higher after last week’s 4.1% drop. Wall Street analysts estimate S&P 500 profits rose by 21% in the third quarter from a year earlier, according to a
Some analysts have said a higher level of stock buybacks could also underpin the market. Share repurchases by many companies slowed in the month leading up to earnings. Companies in the health-care and technology sectors—the market’s leaders this year—are particularly poised to benefit from buybacks,
The performance of individual stocks also tends to be more dispersed on days with more earnings reports, the Bank of America analysts found. That potentially increases opportunities for stock-picking investors.
Although stocks have tended to climb during earnings seasons recently, there have been exceptions. During the busiest part of the reporting season in January and February, the S&P 500 fell 6%, marking the first rout for the equity market in months.
Some investors still warn that the market could also suffer this time around if company executives give cautious outlooks on earnings calls or if comments about the U.S.-China trade dispute lead to more volatility.
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Before last week’s selloff, a reasonable expectation was for a stable market headed into the earnings season that started last Friday. Instead, even before the first major reports came in, stocks plummeted. When such an unexpected event occurs, there are the immediate questions, “Why?” and “What next?” Of special interest is whether the market is finding a new, lower “normal,” or is simply shaking out weaker holders while setting the stage for a new rise. Below are the analytical steps I find helpful.
Disclosure: Author holds U.S. stocks and U.S. stock funds
First, list the potential reasons that are being discussed
In today’s market the focus primarily has been on these possible causes:
Technology companies/stocks coming under pressure
Global trade worries, including tariff effects and China slowdown
Rising interest rates’ negative impacts
Second, identify whether the issues are new or have increased in importance
Technology:Nothing new or increased. The issues of popularity (previous good performance), possible government regulations and the prior week’s declines were all known and discussed.
Global trade: Nothing new or increased. In fact, the uncertainties surrounding tariffs and China have produced volatility for much of 2018.
Rising interest rates: Nothing new or increased. Moreover, this is an area where one-sided, simplistic reasoning is currently ignoring the benefits and incentives created by rates rising – also, that rise is mislabeled as “tight money;” it is simply a return to “normal,” market-determined levels.
Third, if there is no new or increasing negative that is a viable cause of the selloff, is there a reasonable alternative?
This question always raises the issue of insider knowledge: What if “they” are selling because “they” know something that we do not. It certainly can happen with an individual stock, but very rarely with an industry or sector, much less the entire stock market. Therefore, it is best to dismiss this possibility as far-fetched until something is actually revealed.
New discussion: Cold war?
The only “revealed” item that I can identify comes from The Wall Street Journal’s article: “U.S. Edges Toward New Cold-War Era With China.” That scary sounding headline seemingly takes the tariff “war” uncertainty to a new, frightening level. The opening paragraph even implies the White House is considering serious, intense, even physical, tactics:
The Trump administration is moving deliberately to counter what the White House views as years of unbridled Chinese aggression, taking aim at military, political and economic targets in Beijing and signaling a new and potentially much colder era in U.S.-China relations.
However, the article is a collection of what we already know, but the reporters have amped up the negativity and even included some war terminology. Ignored is the other way to view the Trump administration’s new hardline messaging: Frustration from expectations unfulfilled.
“Where this ends is a trade deal,” a senior administration official said. “Xi is starting to look at this and say, ‘Wow, Trump is doing the things he said he’s going to do,’ and realize that he has to get to work.’”
Instead, Xi appears to be fully in control regarding China’s responses to the U.S. tariff actions. Moreover, in spite of the tariffs, President Trump’s key yardstick, the U.S. trade deficit with China, is growing, not shrinking. Hence, frustration.
That leaves bearish feelings as the most plausible source of the stock market selloff
This year’s lengthy stock market meanderings following the sharp, tariff-related drops produced a widespread sense of bearishness. Then, with the recent, steady climb to new highs, that bearishness actually seemed to increase, even accompanied by dire forecasts.
The reasons are numerous, but all suffer from the same two flaws: overly simplistic reasoning (like rising interest rates killing growth) and overly discussed propositions (think about how long we have been hearing the market is overpriced). Additionally, sharp drops require new and unexpected facts; fundamentals that truly adjust valuations downward. Emotionally driven selloffs are, by their nature, unsupported, so can reverse as soon as emotions settle down.
Fourth, explain how the likely alternative might play out
With the third quarter earnings reporting right around the corner, we are about to get new facts: How each company fared this summer and, especially, management’s view of what’s happening in the fourth quarter and what the outlook is for 2019.
With those facts and outlooks, analysts and portfolio managers will drive the discussion of whether a company’s stock is attractively priced or not. Could there be negative surprises from the company reports? Of course. Moreover, if there is a general tone of somewhat lower growth and/or uncertainty, it could adversely affect the overall stock market. Importantly, whatever the results, we can expect reality, not emotions, to be the driver.
The bottom line – what to do now
Watching the bottom drop out of the stock market is unnerving, leaving many investors worried. The best approach is to step back and try to determine the real reasons for the decline, including how those conditions might change.
The analytical process discussed above helps answer the question of what should be done in response to this stock market selloff:
Do not sell – There are no new, significantly negative issues for altering the reasons for owning U.S. stocks
Do not be surprised if the selloff takes a bit of time to end– This is no fun, but when emotions run strong, so can a short-term trend.
Watch for special stocks – The selloff has been broad, taking down even promising opportunities.
Stay calm and let time play out – In the end, it is the only way to know whether this selloff is an adjustment to a new, lower “normal,” or is another unnerving “shakeout” that becomes obvious after the fact.
Last week was a rocky one for the stock market. In a single day, the Dow dropped 832 points, which constituted one of the most substantial declines in its history. The S&P 500 and Nasdaq also took a beating, so much so that if you checked your portfolio at any point last week, there’s a good chance your first inclination was to sell before things got worse.
But hopefully you didn’t sell. Hopefully you did the smart thing by sitting back and waiting to let things play out. And if you didn’t, let this be a lesson: Volatility is a cornerstone of the stock market, and it isn’t actually something to be afraid of.
IMAGE SOURCE: GETTY IMAGES.
The worst way to deal with a stock market decline
One thing you must remember about stock market volatility is that you don’t actually lose money until you react to it. That gasp-worthy loss you might’ve seen on your computer screen last week when you checked your portfolio balance? Unless you sold anything, it was only hypothetical.
Stock market fluctuations — even sizable ones — are completely normal and even somewhat predictable. And last week’s downturn, if we even want to call it that, was by no means catastrophic. In fact, the Dow, S&P, and Nasdaq are still very much up since the start of the year despite the dips they just took.
If you let yourself panic every time the market falls by a few percentage points or even undergoes a full-fledged correction (a decline of 10% or more), you’re going to harm your health and possibly your finances if said panic leads you to make rash decisions. Not only are corrections fairly common — they happen, on average, about once a year — but the market has historically recovered from them and then some.
In fact, the only real way to get hurt by a market dip or correction is to take a short-sighted approach to investing. If your goal is to put some money into stocks and get out quickly, then yes, a decline could spell serious trouble. But if you have a longer investment horizon — say, 10 years or longer — you’re more likely than not to come out ahead, provided you leave your portfolio alone when the market does tumble.
Of course, this doesn’t mean you have to sit back, do nothing, and let those market dips play out. While it’s generally not a good idea to sell off investments during a downturn, one thing you can do is try to capitalize by buying the right stocks on the cheap. But make no mistake about it: The best way to make money through stock investing is to put money into strong companies and hold those positions for the long haul. Loading up index funds is another good option, since these funds move with the broader market and offer instant diversification.
One final thing: Make sure to have a healthy supply of emergency cash in the bank at all times. The last thing you want is for an unplanned bill to land in your lap during a market dip, thereby forcing you to sell investments during a week like this past one.
The new mantra for investors this week may be good things come to those who wait.
Wall Street pundits on Monday continued to urge caution, predicting that the stock market turbulence is far from over. Yet many of them ended their commentary on an optimistic note, suggesting that the bullish backdrop for stocks remains intact.
Stephen Suttmeier, a technical research analyst at Bank of America Merrill Lynch, said there are plenty of oversold stocks and bearish sentiment is on the rise but the market has not quite deteriorated to a point where the negative trend turns into a contrarian indicator to buy.
“More time and downside tests may be needed for a firm market low,” said Suttmeier in a note to clients.
One technical indicator the analyst is watching is the CBOE 3-month Volatility Index/CBOE Volatility Index
ratio which closed at 0.863 on Oct. 11, the “most fearful oversold” since it dipped to 0.758 on Feb. 5.
“Spikes below 1.0 on the VXV/VIX have suggested tactical capitulation and have coincided with important lows on the S&P 500, but these lows sometimes get retested,” he said.
About 46% of S&P 500 stocks are above their 200-day moving averages, the lowest since early 2016, while 12% of stocks were hitting 52-week lows as of last week.
“This deterioration is seen across all the major U.S. equity averages and suggests a weakening or later stage bull trend from early 2016,” he said.
For now, the S&P 500 is trading above its 12-month moving average while its monthly moving average convergence divergence (MACD) — a momentum indicator that illustrates the relationship between two moving averages of prices, remains a buy signal. But if the S&P 500 12-month moving average falls below 2,747 and the monthly MACD switches to a sell signal, the risk for a bear market will rise, according to Suttmeier.
Another metric to keep an eye on is the high-yield option adjusted spread—the premium that investors demand in return for owning riskier debt over investment grade.
“The big level to watch on the high yield OAS is 3.68-3.72 (2018 peaks). A break above this level would point to increasing credit market stress and likely confirm a failed breakout in the S&P 500 ahead of a bigger equity market pullback,” the analyst said.
The high-yield OAS traded at 3.44 last week.
Key support ranges to monitor for the S&P 500, levels where investors feel comfortable about buying back into the market, are 2,729 to 2,710 and then 2,692 to 2,676.
But as bad as things look, there are reasons to be upbeat.
“Many people focus on ‘sell in May and go away’ but the better and much less well known pattern for the market is ‘buy in October and stay’,” said Suttmeier, who pointed out that November to April is a good time for stocks.
Going back to 1928, this six-month period has been up 71% of the time for an average return of 5.07%. This time, it could be even more bullish given the traditional boost from a midterm election year, he added.
Tony Dwyer, chief market strategist at Canaccord Genuity, likewise predicted that it could take some time for the pullback to resolve itself.
“We find it unlikely there will be a V bottom given the sharpness and breadth of the correction,” he wrote in a Monday note.
In fact, he went as far as to hint that the market’s rally to 3,200, which he had predicted by the end of the year, could be delayed into 2019 depending on how long it takes for the market to bottom. However, he stopped short of revising his outlook and reiterated his view that the current period of weakness is likely to be temporary.
“It is essential to remember that while any number of fundamental excuses could be used, this correction was born out of 1) excessive optimism; 2) an extreme intermediate-term overbought condition; and 3) historically low volatility – rather than a significant enough fundamental change that would suggest a shutdown of credit, and ultimately negative EPS,” he said.
Here is Dwyer’s checklist of tactical indicators to watch:
Meanwhile, David Kostin, chief U.S. equity strategist at Goldman Sachs, reminded investors that 5% drawdowns are fairly common.
“Since 1928, the index has typically suffered a 5% pullback once every 71 trading days. 69 trading days elapsed between 5% drawdowns prior to Thursday,” he said.
The good news, though, is that Goldman strategists do not see much significant upside to bond yields and expect the 10-year Treasury yield
to close out the year at 3.1% compared with 3.161% currently.
Kostin stuck with his year-end S&P 500 target of 2,850, noting that the probability of a recession in the next three years is roughly 37%.
“The year to date surge in EPS combined with a modest climb in S&P 500 has reduced forward P/E multiples by 14% to 15.7 times, reducing valuation risk for equity investors,” he said.
One indicator that Kostin finds encouraging is the strong return on equity, a popular gauge for corporate profitability, which rose to 17.5% in the second quarter, among the highest in the past 40 years. Excluding financials, ROE hit a record of 20.7%.
Still, the strategist expects companies to feel some margin pressure given higher interest rates and recommended investors to focus on corporations with strong balance sheets such as TripAdvisor Inc.
The heaviest selling of the week was on Wednesday and Thursday, when the Dow plummeted nearly 1,400 points, or more than 5.2 percent, in the two sessions.
Despite a strong rebound on Friday, the Dow and S&P 500 fell more than 4 percent for the week. The Nasdaq dropped nearly 3.75 percent for the week.
“What they’re doing this week is like a man in a dark room. Just reaching out to find out which way it can walk and not stumble,” Cashin, director of UBS’ floor operations at the New York Stock Exchange, said on “Squawk on the Street.”
Last week’s decline was fueled by concern the Federal Reserve might raise rates more than forecast. The central bank has already hiked rates three times this year, and one more is expected in December.
Stocks were slightly in the red at midday Monday, with tech stocks like Apple and Netflix bringing the Nasdaq lower. Cashin expects the technology sector to continue to be an underperformer.
He also said “a lot wild cards” could impact the market this week.
CEOs pulling out next week’s Saudi investment conference could have an impact on stocks, Cashin said, but as of right now there are minimal signs in the financial or oil markets.
U.S.-China trade tensions also remain a concern, Cashin said. Most recently, the U.S. levied duties on $200 billion worth of goods from China, prompting Beijing to put tariffs on $60 billion worth of U.S. goods.
Cashin began his career in 1959 at Thomson McKinnon. In 1964, at age 23, he became a member of the NYSE and a partner in P.R. Herzig & Co.
Maybe investors should be getting more accustomed to stock-market plunges akin to those that rippled though markets last week, knocking more than 830 points off the Dow Jones Industrial Average on Wednesday and leaving the blue-chip gauge and the S&P 500 with their worst declines since February.
They might also take comfort from history, which also indicates that when they occur, a market bottom usually isn’t too far away.
“If sudden market plunges out of nowhere seem to be happening more frequently than in the past, it’s not just you,” wrote Pravit Chintawongvanich, equity derivatives strategist at Wells Fargo Securities, in a Monday research note.
Such sudden bursts of volatility have become more frequent in the past few years, he said, pointing to the chart below.
The graphic looks at days when the ratio of 5-day to 3-month realized volatility exceeded 3. “In other words, days when there is a huge burst of volatility compared with what’s been the norm,” Chintawongvanich wrote. Since 2007, there have been six such events versus only five in the preceding 50 years. In fact, a 22-year stretch from 1964 to 1986 didn’t see a single one, he noted.
fall 3.3%, while the Dow dropped 831.83 points, or 3.2% — the biggest one-day drops for each since Feb. 8.
The striking thing about almost all these events, he noted, is that market bottoms were usually within a few percentage points, producing a small drawdown on average. And in almost every instance, stocks were higher within the following three months.
But it also indicated that things got bumper, he said, with realized volatility typically higher after the event.
Chintawongvanich took a stab at explaining why such eruptions of volatility tend to mark a bottom or at least a near-bottom. He concludes that, most likely, it’s because the downdrafts are more about liquidity — and the temporary lack thereof — than any sudden change in market fundamentals. He writes:
If the market suddenly has a huge selloff out of nowhere, then either 1) the economic fundamentals have instantly changed from yesterday, 2) the market collectively decided stocks are much more risky than they were yesterday, or 3) more liquidity was demanded than the market could provide. It is unlikely 1) fundamentals is the case today—most would agree economic fundamentals haven’t changed from a week ago. 2) higher risk premium could possibly be the case—after all, if 10-year yields are higher, perhaps the equity risk premium should be higher, there are some worries about earnings growth, margins, trade, and so on. But the real reason is probably 3) lack of liquidity, or more specifically that selling because of 1) and 2) led to a problem with 3). At any rate, if stocks are down because more liquidity is demanded than the market can supply, they should go back up once the liquidity demand goes away. That should be true whether the liquidity is demanded by “portfolio insurance”, CTA robots, or good old fashioned human traders.
But why are these events more frequent? Chintawongvanich said it’s possible that market structure has changed. That could come from the demand side, via increasing use of options and related products and strategies, or on the demand side from the rise of high-frequency trading and other developments.
Regardless of the reason, investors can at least take comfort in knowing it isn’t all in their heads.