Panic has taken hold.

While it’s probably risky to put anything into writing amidst the stock market’s current bout with panic, we feel it’s important to provide some context for what’s going on in real time.  First of all, corrections and bear markets happen; they’re part of the circle of life, unfortunately.  Just because they happen doesn’t mean that the end of the world is coming next.  The stock market is typically volatile; a correction (a drop of 10-20%) happens every year or so.  Bear markets happen every 3.4 years, on average.  While most people believe that bear markets only coincide with recessions, just as many bear markets have not.  2011, 1998, 1987, 1978, 1966, and 1962 were among them.   These markets fell 20-28%, except 1987 (the Black Monday crash), which saw a 35% decline, yet eked out a gain for the calendar year.

From where we sit right now, the S&P 500 was oh so close to bear market territory on Monday (Christmas Eve) and again early Wednesday, meaning that the index was just about 20% down from its high in late September.   After touching those lows, the market rallied both times, and in impressive fashion Wednesday, the Dow closed up an all-time record 1,086 points.  Then yesterday, the Dow reversed a 611 point intraday drop and closed up 260.  Most world markets were/are down more than 20% from their 2018 highs, meaning they are in bear markets, and most U.S. indices, including NASDAQ, Russell 2000 (small-cap stocks), and S&P Midcap indices were down more than 20%.  This same phenomenon happened in 2011, and 2015 was similar. 

So does it matter whether a market enters bear market territory or not?  Not really, but because the terms attract so much attention, traders do pay attention.  You will see traders get emboldened to buy or sell based on certain technical indicators.  If they see the market becoming more fearful, traders will short stocks, meaning they will profit if stocks drop more.  It is herd mentality, but as long as the herd is running the same direction, no one gets trampled.  When does this end?  Typically, it’s when fear and panic are at their maximum.

We think the market might have reached that point on Christmas Eve.  How do we know?  There are indicators that measure it, and we can compare readings to those of past bear markets and corrections.  We show them below.  The first table is from last Friday, so inevitably these numbers got considerably worse on Monday.  The number of stocks in each sector down more than 20% from their highs was 68% of the S&P 500.  This was near the number at the low of the market in 2011, and worse than the low in 2016.  But in 5 sectors, the number of “way down” stocks is higher than in 2011, notably including consumer staples, a sector which has outperformed the market by 10% in the 4th quarter alone, down 7% versus down 17%.  But 61% of stocks in the sector are down more than 20%, notably food stocks.  A few megacap stocks, notably Coke (up 4%) and P&G (up 7%), have really outperformed in the 4th quarter.

The next chart shows the number of stocks in the S&P 500 trading at their yearly low, up to 50% now.  This is higher than the 40% seen at the lows in 2011 and 2016.  The third chart shows the number of stocks still trading above their 200-day moving average, now at only 10%, compared to 9% and 18%.  The fourth chart shows that the AAII “Bull/Bear” sentiment survey of individual investors has almost never been lower than now, at 0.5 (twice as many bears as bulls).

Finally, the put/call ratio shows the amount of trading in put options (which are bets that a security’s price will drop) compared to trading in call options (which are bets that a security’s price will rise).  It has spiked to 1.4, which is well above those correction lows, and also above every bear market and financial crisis low, going back more than 30 years.

While we wish these indicators would give us the “all clear,” they are more apt descriptions of where the market has come from, rather than where it is going.  It might be that the market continues its recent upward rally, then fades and retests these lows.  But they do at least set a good base of a panic-sale low.  We are also very aware that “algo trading,” or what used to be called “program trading,” has become 85% of trading during the last few weeks.  When the market drops so quickly (10% in 6 ½ trading sessions), something is amiss, and the answer is probably algo trading.   The result has been tangible:  buyers get scared off, and probably a lot of individuals, acting out of fear, cave in and sell as the market tanks. 

We haven’t changed our forecast for the economy since our last update 3 weeks ago at our lunch seminar:  still solid 2-3% growth, led by 4-5% consumer spending growth, supported by 3% wage growth, and single-digit corporate profit growth.  It would be almost without precedent if the market weakened further in the face of a solid economy.

While we generally maintain a long-term belief in stocks that vacillates between optimistic and guardedly optimistic, we have always tried to convey that there will be bad markets.  We have always tried to ensure that our clients are prepared for anything, and that their financial well-being will not be damaged by a correction or bear market.  If you are concerned about anything, please don’t hesitate to reach out to us by phone or email.

%
% of stocks still trading above 200-day moving average
AAII bull/bear ratio
Put/call ratio

Leave a Comment

Your email address will not be published. Required fields are marked *