Monday, December 24, 2018

Could The Stock Market Crash? Perspectives From Market History
Brett Steenbarger

From what I'm hearing from traders and investors alike, there is pervasive concern over the possibility of a bear market in stocks. It's in the media as this article...and this. We're currently seeing the highest equity put/call ratios in years, with many more put options (downside bets) being placed relative to call options (upside bets). Moreover, if we look at the data tracked by Index Indicators, we find that fewer than 10% of stocks in the Standard and Poor's 500 Index closed on Friday above their 3, 5, 10, 20, 50, and 100-day moving averages. Rob Hanna has noted a high degree of capitulation among stocks, a condition he notes has generally led to rallies in the past (though the exceptions to that pattern have been painful).

I first noted a yellow caution light on the stock market in September, as flow measures tracking upticks and downticks across the broad universe of NYSE stocks displayed significant recent weakness. I described in mid-December the unusual weakness in the market and amidst a collapse of buying flows and global economic concerns. Those flows have not materially improved since then. The inability to sustain strength from very oversold conditions of bearish sentiment has been startling.

Years ago, I worked with a talented RV manager who liked to initiate positions when the spreads between assets became "silly". Every so often, those spreads would widen even more, at which point he referred to them as "stupid". We used to joke that his best opportunities always followed from levels that were "stupid". The key, he noted, was to have dry powder on those occasions. That lesson stuck with me. Sometimes we have to hit stupid levels of valuation before value becomes compelling and worth the risk of all we hear about in the news.

Perspectives from market history are helpful here. Nothing progresses in a straight line. If you look at the history of big bear markets, there is usually a harrowing initial decline lasting several months followed by a rally that retraces a decent portion of the drop, taking out the bears. It is from that lower high that the major part of the damage from the bear occurs.  Let's examine some examples:

Initial Drop:  June, 1901 - December, 1901 -  Dow 78.26 - Dow 61.52

Rally:  December, 1901 - April, 1902 -  Dow 61.52 - Dow 68.44

Bear Decline:  April, 1902 - November, 1903 -  Dow 68.44 - Dow 42.15

Initial Drop:  September, 1929 - November, 1929 - Dow 381.17 - Dow 198.69

Rally:  November, 1929 - April, 1930 - Dow 198.69 - Dow 294.07

Bear Decline:  April 1930 - July, 1932 - Dow 294.07 - Dow 41.22

Initial Drop:  January, 1973 - June, 1973 - Dow 1051.70 - Dow 869.13

Rally:  June, 1973 - October, 1973 - Dow 869.13 - Dow 987.06

Bear Decline:  October, 1973 - December, 1974 - Dow 987.06 - Dow 577.60

If we look at more recent bear market periods, a similar pattern emerges. The initial declines from March, 2000 to April, 2000 (particularly steep in the NASDAQ Index) and from October, 2007 - January, 2008 were followed by nice bounces (April, 2000 to August, 2000 and January, 2008 to May, 2008) and then by steep declines into bear lows (August, 2000 to October, 2002 and May, 2008 to March, 2009).

It isn't necessary to resort to mystical wave counts, Fibonacci levels, and chart patterns to explain what happens in bear markets. It's all about stopping out the crowds. The euphoric bullish crowds are stopped out on the initial down leg; the desperate bears are stopped out on the rally leg; and the now comfortable bulls (and remaining longer-term bulls) are stopped out on the bear move to lows.

Rinse and repeat.

Given that historical perspective, here's one possible take on recent market activity:

In the future we may well look back on the period of easy money from central banks as a period of euphoria, taking us to all time bull highs--perhaps not so different from how we now view 1929. With the removal of monetary punch bowls; growing political and economic populism/nationalism; and slowing global economic growth, we're now possibly seeing the first leg down in a bear market. If history repeats, we should see a decent rally ensue from very oversold levels and highly bearish sentiment. Also if history repeats, that rally could lead to a more protracted downside, perhaps connected to the unwinding of debt incurred during the punch bowl years.

Market history tells us that this sort of thing has been going on for a while. We had a bottom in the early 1900s and then almost 30 years of bull market. We had a bottom in the 1930s and over 30 years of bull market. We had a bottom in 1982 and over 30 years of bull market. There are secular bull markets and there are secular bears. One need not be an irrational permabear to speculate that one of these longer cycles could be playing out now. Indeed, if you look at market levels at the bear lows over the decades, you'll notice an even more secular, very long-term rising trend in equity prices, as noted by Dimson, Marsh, and Staunton.  The big bear markets have been wonderful investment opportunities--but only for those who preserve their capital.

As I pointed in a recent blog post, my job is to entertain plausible hypotheses, not become locked in fixed conclusions. I monitor the daily strength and weakness of the market with various tools grounded in market microstructure (the blog tracks those periodically) and periodically update my priors. I would be only too delighted to see emerging strength and a rejection of the hypothesis that we're now seeing the first leg of a bear market. So far, however, the flow data have made it impossible to reject that hypothesis.

Should history play out once again, I fear that many baby boomers locked in portfolios of stocks and higher yielding bonds will enjoy fewer retirement nest eggs. As the old saying goes, there's a role for pursuing a return on your capital and there's a role for pursuing a return of your capital. Trading psychologists and investment advisers who counsel "stick to your discipline" and "follow your plan" are correct as long as the secular cycles move in a nice, trending way. That same advice at major turns can become devastatingly destructive. Market history does not offer an infallible path to the future, but it does suggest that those who fail to learn from the past will be destined to repeat it.

I am Clinical Associate Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY. I work as a performance coach for hedge fund portfolio managers and traders and have written several books on trading psychology.

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