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posted on 06 February 2018

How Has The Market Behaved After Prior Sharp Declines?

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The common thread in the following examples of sharp declines in the S&P 500 is they occurred while economic growth was strong. Although the declines in the stock market sometimes exceeded 20%, they did not adversely affect the economy which enabled the S&P 500 to resume its advance after testing the initial spike low usually within two months.

v.shaped.recovery


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1987

Although bond yields rose sharply before the 1987 Crash, the economy was strong. The primary culprit in the 22% loss on October 19, 1987 was the use of Portfolio Insurance which resulted in mechanical selling. Since the economy was not impaired, the S&P rallied after a retest of the initial low.

Click on any chart below for large image.

1998

The 22.6% correction in the summer of 1998 was precipitated by the demise of Long Term Capital Management which had leveraged investments 100 to 1 in European and Russian bonds. When Russia defaulted, LTCM collapsed. The economy was not impacted and the S&P resumed its uptrend after testing the initial low.

2010

The Flash Crash in May 2010 caused the DJIA to lose 1,000 points in less than 10 minutes and then recover in less than 2 hours. It was triggered by faulty processes in electronic trading and stop loss orders under the market which caused selling to cascade. After recording a modest lower low in late June and down 17.1% from its May high, the S&P began a strong rally. The economy was in good shape.

2011 In August 2011 U.S. debt was downgraded by a major credit rating from AAA to AA which led to a very sharp decline of 21.5%. After a robust rebound, the S&P 500 recorded a modest lower low in early October before resuming its uptrend. See chart above. Despite the almost 20% decline, the economy was fine

2015 and 2016

In August 2015, China devalued its currency which led to a sharp decline in the S&P 500 of 12.4%. After the S&P 500 retested the spike low in late September, the S&P rallied to challenge its high. In early 2016, oil prices were in freefall which spilled over into energy bonds and a 14.4% decline in the S&P. After a retest of the low in February, the S&P 500 resumed its move higher. Although the economy slowed modestly, GDP continued to grow near 2%.

2018 The 10-year Treasury yield broke out above its March 2017 high at 2.63% triggering a modest pullback in the S&P 500. The severity and intensity of the decline on February 2 and February 5 was due in large part to an enormous short position in the volatility (VIX) futures. As volatility became progressively more compressed in the last two years, hedge funds and other investors have piled into the short VIX trade since it was very profitable. The net result is this is a crowded traded. When the S&P closed at 2873 on January 26, the VIX closed at 11.06. As the S&P began to slip on January 30, the VIX rose more sharply than would be implied by the small percentage of decline in the S&P 500. During the 4 day period from January 26 and February 1, the S&P dropped just 1.77%, but the VIX had jumped by 21.8%, closing at 13.47 on February 1. The sharp increase in the VIX began to pressure those who had shorted the VIX below 11.0 in October, November, December and early January. On Friday the VIX closed at 17.31 or 56.5% above the January 11 close and after a decline of just 3.9% in the S&P 500. Some of the VIX instruments employ leverage of 2 or 3 to 1, while the VIX futures have leverage of more than 15 to 1. The forced liquidation of VIX positions led to margin calls. Those who are short the VIX needed to come in with more money to maintain their position, or needed to sell other investments to meet the margin call.

With volatility remaining so low for so long and the absence of a decline of any magnitude, some investors implemented leveraged ETFs to amplify returns on the S&P 500, DJIA, Nasdaq 100, and Russell 2000. These leveraged ETFs use leverage of 2 to 1 or 3 to 1. Life has been a bowl of cherries as the major market averages only went up. Investors in 3 to 1 ETFs absorbed losses of 7% or more on February 2 and 12% or more on February 5. As these losses piled up, investors sold their leveraged ETFS either due to margin calls or out of fear. The ETF providers were then forced to sell the stocks in the indexes ie S&P 500, DJIA, Nasdaq 100, and Russell 2000, which is why the market closed near or at the lows of the day on February 2 and 5th.

Since the economy is in good shape, the decline in the S&P 500 is unlikely to impair GDP growth in coming months. If the past is any guide, the S&P 500 is likely to rally and then retest the low on February 6 in coming weeks before resuming its rally.

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