It Wasn’t a Crash – But it Could Become One

Submitted by Pater Tenebrarum  –  The Acting Man Blog

A Reminder by John Hussman

In light of the Nikkei Index soaring by more than 1,300 points (!) overnight – a single day gain of 7.7% – it is time to briefly review the current market situation. As to the Nikkei, we would note two things: 1. it was “catching up” to what other markets have been doing, after having been the only stock market index that was significantly down the previous day (whereas all other markets soared after the close of trading in Japan) and 2. such enormous volatility – regardless of its direction – is usually not a bullish sign. Quite the contrary, in fact.

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Nikkei, dailyThe Nikkei jumps by 1,343 points overnight – click to enlarge.

In his weekly market comment, John Hussman tries to defuse the hysteria surrounding the recent market break a bit, by reminding everybody that a 10% correction is not a “crash”, but actually a quite normal occurrence. The only reason why it felt abnormal was that there hasn’t been any market volatility for such a long time. It is this long absence of market volatility that was abnormal, not the 10% decline. He writes:

“The market decline of recent weeks was not a crash. It was merely an air-pocket. It was probably just a start. Such air pockets are typical when overvalued, overbought, overbullish conditions are joined by deterioration in market internals, as we’ve observed in recent months. They are the downside of the “unpleasant skew” that typically results from that combination – a series of small but persistent marginal new highs, followed by an abrupt vertical decline that erases weeks or months of gains within a handful of sessions (see Air Pockets, Free-Falls, and Crashes).

Actual market crashes involve a much larger and concerted shift toward investor risk-aversion, which doesn’t really happen right off of a market peak. Historically, market crashes don’t even start until the market has first retreated by 10-14%, and then recovers about half of that loss, offering investors hope that things have stabilized (look for example at the 1929 and 1987 instances). The extensive vertical losses that characterize a crash follow only after the market breaks that apparent “support,” leading to a relentless free-fall that inflicts several times the loss that we’ve seen in recent weeks.

[…]

The reason why the word “crash” has been bandied about to describe the recent selloff, I think, is partly because investors have lost all perspective of the losses that have historically been associated with that word, but mostly because it gives market cheerleaders the needed “cover” to encourage investors to continue speculating near record market valuations. After all, everyone “knows” that investors shouldn’t sell after a crash, thus the endless flurry of articles advising “selling in a crash is a textbook mistake,” “selling off stocks during a crash is a terrible idea”, “whatever you do, don’t sell”, “market crash: don’t rush to press the panic button,” “the worst investing move during a market crash,” … you get the idea.

Hand-in-hand with the exaggeration of the recent decline as a “crash” and “panic” is the exaggeration of investor sentiment as being wildly bearish. The actual shift has been from outright bulls to the “correction” camp, but that’s a rather meaningless shift since anyone but the most ardent bull would characterize current conditions as being at least a market correction. Historically, durable intermediate and cyclical lows are characterized by a significant increase in the number of outright bears. That’s not yet apparent here. Indeed, Investors Intelligence still reports the percentage of bearish investment advisors at just 26.8%.

It’s generally true that one doesn’t want to sell stocks into a crash (as I’ve often observed, once an extremely overvalued market begins to deteriorate internally, the best time to panic is before everyone else does). Still, the recent decline doesn’t nearly qualify as a crash. For the record, those familiar with market history also know that even “don’t sell stocks into a crash ” isn’t universally true. Recall, as an extreme example, that from September 3 to November 13, 1929, the Dow Industrials plunged by -47.9%. The market briefly recovered about half of that loss by early 1930. Even so, it turned out that investors would ultimately wish they had sold at the low of the 1929 crash. By July 8, 1932, the Dow had dropped an additional -79.3% from the November 1929 trough. In any event, the recent market retreat, at its lowest closing point, took the S&P 500 only -12.2% from its high, and at present, the index is down just -9.7% from its highest closing level in history. To call the recent market retreat a “crash” is an offense to informed discussion of the financial markets.

(emphasis in original)

Luckily we only called it a “mini-crash”, so our offense with respect to informed discussion of financial markets can probably be classified as only a minor infraction…:)

Anyway, we did point out that we regard the recent volatility as a “warning shot” and we still do so. In our discussion of the probability of an emerging panic (see The Market’s Panic Potential for details), we noted that “the odds favor a warning shot scenario, but there is a ‘but’”. We pointed out that:

“The sheer speed of this decline masks the fact that the S&P 500 is actually only 163.83 points or 7.67% below its all time high made in May. In other words, this decline doesn’t even amount to a routine 10% correction yet. And yet, as Zerohedge reports , cries for intervention by the Fed are amusingly already going up. We actually don’t believe that the federal purveyors of Anglo-Saxon central banking socialism will jump into the breach that quickly.”

[…]

If this is a “warning shot” scenario in an emerging downtrend, then one should expect a low to be put in over the coming days, followed by a rally that fails at a lower high. Thereafter the selling should resume.

[…]

That the potential for such a panic exists is mainly given by the unusual nature of this decline – its commencement during expiration week, and its suddenness and ferocity to date.

We see no reason to change this assessment. The market has indeed put in a short term low shortly after the above was written, and since then a volatile recovery has been underway. It continues to have all the hallmarks of an emerging panic, even though we must concede that a resumption of the previous bullish trend is on the surface not distinguishable from a market moving toward a selling panic.

SPXA daily chart of the S&P 500 that shows the main lateral resistance zones. There is nothing unusual about the rebound, and it leaves all options open – click to enlarge.

The Really Important Points

Mr. Hussman also reminds us of what is actually important with respect to expected future returns. Unlike Mr. Levkovich of Citigroup, who “knows” that there is a 96% chance (!) that the market will be higher than today 12 months hence (where do they find these people?), Mr. Hussman simply points out that the preponderance of evidence points to poor long term returns for today’s buyers.

See also the excerpt further above with respect to the continual refrain about how “bearish” everybody allegedly is. Surely this has to be questioned with just below 27% of advisors in the II survey declaring themselves to be in the bear camp. It doesn’t exactly appear as though the concerns of most market participants/ observers were extremely elevated. As Hussman writes regarding what is really important:

To understand the market cycle is to understand this: Valuations are the primary driver of long-term investment returns, but returns over shorter portions of the market cycle are driven by the attitude of investors toward risk, and the most reliable measure of this is the uniformity and divergence of market internals across a broad range of individual securities, industries, sectors, and security types, including debt of varying creditworthiness. When investors are risk-seeking, even extreme valuation may have no immediate consequence. When investors shift to risk-aversion, previously irrelevant overvaluation can suddenly matter with a vengeance.

Given the market return/risk profile we currently identify, we doubt that what the Fed does in September will make much difference in the ultimate outcome of this market cycle. As for shorter-run outcomes, the effect of Fed policy on the financial markets is determined by the risk-seeking or risk-aversion of investors, so the thing to watch is the behavior of market internals.

Despite hypervalued and overbullish market conditions, quantitative easing encouraged much more sustained risk-seeking in recent years than we’ve observed in prior market cycles across history. Overvalued, overbought, overbullish extremes that were historically followed by rather immediate market collapses were instead followed in recent years by continued speculation. One had to wait for market internals to explicitly deteriorate before taking a strongly negative market outlook (see A Better Lesson than “This Time is Different”). However, we also know from a century of history, including the 2000-2002 and 2007-2009 plunges, that monetary easing does nothing to prevent hypervalued markets from collapsing once investor preferences shift toward risk-aversion. That shift has been evident since the third quarter of 2014 through increasing dispersion and deterioration in market internals.

(emphasis added)

The “dispersion and deterioration in market internals” certainly remains in evidence. A number of sectors in the economy have come under pressure due to the weakness in global trade and the concomitant sharp decline in commodity prices. This is inter alia reflected by the increasing loss of uniformity in market internals.

The important thing to watch is therefore whether this changes. Note however that if for instance commodity-related sectors were to begin to firm up, it could well be that other sectors concurrently begin to weaken, which would leave the lack of trend uniformity in place. There is no law that says that if the prices of crude oil and copper make a low of some sort and embark on a short to medium term uptrend, stock markets have to follow suit.

And QE by the Fed has ended – QE by the ECB and BoJ can to some extent offset this, but the policies of the central bank issuing the global “reserve currency” are still the ones that are most important for global risk asset prices.

Financial Stress IndexSt. Louis Fed “Financial Stress Index” – rising from an extremely low level since 2014 – recently it has broken out to a new high for the move. We would closely watch the 2011 high in this measure – if it is exceeded, all hell is likely to break loose.

Conclusion

It is important to differentiate between time frames when assessing the market. Mr. Hussman has been widely denounced as a ‘perma-bear’, but this is actually not a fair characterization of his views. Certainly, like many other Cassandras (including us), he has underestimated the effect unorthodox monetary policy would have on the willingness to engage in rank speculation so shortly after the system’s near death experience in 2008. However, that doesn’t alter the fact that valuation remains the most important predictor of long term returns(surely it isn’t too difficult to grasp this concept, although it seems to elude many other “experts” from what we can see).

In the short term valuation is often meaningless, but market internals, leverage and positioning are all the more important. To this it should perhaps be added: the longer the market seemingly defies the message from deteriorating internals, the more pronounced the eventual denouement will be. This is also why the normally very low probability of a crash becomes more elevated at junctures such as the current one and shouldn’t be cavalierly dismissed.