In my firm’s newsletter last month I pointed out that the S&P 500 had been showing some technical signs of weakness, with the index falling below its 50-day moving average and with the 50-day moving average plateauing at that time. I also pointed out the lack of breadth, with the number of stocks making new 52-week highs declining while the number making 52-week lows was rising, all while the index continued to move up, which makes for an unstable market. I’ve frequently commented on the unusually low levels of volatility, which is likely due to actions taken by central bankers, but can’t last forever and typically leads to heightened future volatility – it’s here!
The technical breakdowns and suppressed volatility came to a head over the past few weeks. On August 25, the 3-day sum of the prices of the S&P 500’s distance from its 50-day moving average, (which is a measure of just how much recent prices differ from the recent past averages) almost beat its biggest day in history – May 15th, 1940.
On that day in 1940 the German Blitzkrieg moved into northern France, German troops occupied Amsterdam with General Winkelman surrendering, General Dutch Persbureau was captured by the Nazis and the Dutch troops surrendered to the Nazi’s, beginning what was to be 5 years of occupation for that nation. So yeah, last time around it was a pretty bad day. The chart below illustrates just how dramatic the moves were relative to norms!
On Monday 8/24 the markets experienced their biggest two and three day declines since the start of this bull market. Tuesday 8/25 was the worst four day rate of change since the start of the bull market. There wasn’t a Mylanta, Zantac, Pepto or Tums to be found on shelves in Manhattan, with the Dow Jones Industrial Average getting hit the hardest, down 12.1% since the start of the year while the S&P 500 was down 9.29% and the NASDAQ was down 4.85%.
Just when all seemed lost, on Wednesday things started to turn around, with the S&P gaining more than on 99.3% of all days in its history! So, yeah, it was a pretty good day. Thursday the S&P 500 was up the most over any two-day period during the recent bull market and was up more over the past five days than in 98.7% of all days in its history! By Friday the Dow Jones Industrial Average closed the week down 6.6% since the start of the year while the S&P 500 was down 3.4% and the NASDAQ was actually up 1.95%.
The market movement was so wild that the CBOE Volatility Index (VIX), a popular measure of implied volatility of the S&P 500 index options, rose 217% from August 14th to August 24th. Last week alone it rose by 120%, which is the biggest rise in history! This was even more dramatic that what we experienced during the financial crisis!
Market volatility has been like a 5-year old, locked in a tiny room, furiously chowing down on last year’s Halloween booty. The lock finally gave way and all you could do was let him have his tantrum!
One reason for the wild swings has been the absence of liquidity, which in a downward moving market simply means sellers can’t find a buyer… at any price. This was in no small part due to the unintended consequences of Dodd-Frank a situation that many have been warning about for years to no avail. While it became popular to malign proprietary trading by the banks post-financial crisis, that same proprietary trading has in the past provided the market with willing buyers, the banks, during times of market turmoil, which helped provide a price floor. The new rules in Dodd-Frank prohibit much of such activity, so when folks panic, there is no one available on the bank trading desks to buy what investors are desperate to sell – the floor is no longer there. This time, it really is different.
All that got investors seriously nervous, with the daily outflows from equity funds hitting their highest levels since 2007 as folks panicked and sold, sold, sold. For the entire week ending August 28th, nearly $30 billion left the equity markets which is the worst since Band of America Merrill Lynch has been recording data back in 2002.
All those that sold though, missed out on the turnaround in the second half of the week. The mid-week turnaround was likely induced by a combination of New York Fed President Dudley’s comments that a September rate hike was “less compelling” than it was a few weeks prior, the actions taken by China to reflate its markets, and overall investor selling fatigue – markets never go straight down. We continue to be amazed at the continued contradictory statements coming out from the various Fed officials! We still think that more volatility is more likely than not and suspect that the current shake out isn’t over quite just yet, but remember investing is always about probability, there are no certainties.
So, is this is just a correction within an ongoing bull market or has a new cyclical bear market begun? Only time will tell which is truly the case. What we can say with a high level of confidence is that the initial decline in either case, will typically lead to a subsequent bounce and ultimately retest previous lows. The big question is whether, with economic growth rates slowing and deflationary pressures building, will the Fed again intervene by postponing rate hikes and possibly even injecting liquidity as it has done for every prior market downturn during this cycle? More on that later!
What caused such a rapid and large decline?
Most people are pointing to the correction in China, both the economy and stocks, as the cause of the recent rout, but we think that is too simplistic. While we think it may have been the catalyst, the proverbial straw that broke the camel’s back, there are other realities that have been making a correction increasingly likely:
- The discrepancy between earnings and top line revenue that has been going on for quite some time
- Slowing global growth