What a month! And we’re only halfway through it! Well, more than halfway I guess, February being a short month and all...let’s recap what we’ve seen so far:
- The market (Dow Jones Industrial Average) lost 1,033 points last Thursday (2/8). That would have been the largest single-day point total drop in history. Ever. Would have been, except that on Monday (2/5) of last week it dropped 1,175 points.
- Two 4%+ down days in a week led to the fastest correction (defined as a 10% decline from a new high) in 80 years (outside of an outright market crash). It took all of 9 days for the market to drop over 10%. That’s pass out from the g-forces fast.
- And after ending on that note last Friday, this week the market responds by having its best week in nearly a decade.
Everyone has heard of bulls and bears in relation to the stock market we’re sure, but have you heard of the cat? It’s a dead cat, to be precise. And probably the third most-alluded to animal in stock market commentary. If only we had a research assistant who could fact-check these claims…
In stock market literature, bulls can represent people, sentiment, or overall market conditions. The same goes for bears. Dead cats, however, can only do one thing - bounce. A dead cat bounce is when something (a stock, an index, the market, whatever) falls, then bounces back a little bit, then falls more. I guess presumably in the same way that a cat would fall and then bounce (assuming it fell from high enough up), and so you think it’s alive and well (when viewed from said high vantage point), but it actually turns out that was life number 9 for the cat and so it lands not on its feet to saunter away, but rather awkwardly on its side (probably) because it is, in fact, dead.
So, the million dollar question: That “best week in a decade” statistic...is it real, or is it just a dead cat bounce?
To answer that question, let’s back up a little and look at the “why” behind the market correction two weeks ago. Or rather, what we were told the “why” was.
The talking heads on radio and TV and whatever finance blog you prefer had all the answers last week. They made it sound as plain as day why the markets were going down. The thing is though, they were pretty much all wrong. Anything you heard - “it’s the robots”, “investors are worried about the increasing costs of doing business”, “interest rates are rising” - it doesn’t matter what it was or where it came from; it was at the very least horribly incomplete, and potentially just outright wrong.
Why do markets go up and down? The truth is that nobody really knows. Or knows how to predict it at least. Not in the short-term. It’s largely a psychological and behavioral phenomenon that just happens, but that doesn’t sound particularly convincing if you’re on TV, so you make up some ex post facto explanation.
"Oh, interest rates have been rising.” Interest rates have been rising for years now. Why did that all of a sudden matter last week? What made 2.88 on the 10-year the Maginot Line last week and then have zero impact this week?
"Oh, all the trend-following momentum strategies (“robos”) sold, and then all the target volatility strategies like risk parity had to sell”. Well, okay, there is some kernel of truth buried in there, but wildly distorted. As a rough estimate, there is maybe $1 trillion in those kind of strategies. Which sounds like a lot, but relative to the size of the mutual fund industry ($18 trillion or so) and the total size of just the US market ($30 trillion or so)...it’s not quite statistically insignificant, but let’s just say your p-value is way over 0.05 if you’re using those funds to predict market movement.
"Oh, inflation came in higher than expected”. Yeah, it also came in higher than expected this week and everything went higher. Stocks, long treasuries, gold. Everything.
None of those explanations are inaccurate statements, per se, but none of them give the whole story. A better explanation for the correction last week would be “people wanted to sell stocks (for whatever reason) a lot more than people wanted to buy them”. But that’s not terribly satisfying, is it? So you look at whatever the most proximal data point was to the start of the decline, et voilà! Post hoc, ergo propter hoc.
In reality, stocks are only worth what people are willing to pay for them. There are all sorts of valuation metrics and equations out there to try and tell you if stocks are “cheap” or “expensive”, but there’s no single intrinsic value of what a stock should be worth. If people want to buy a stock more strongly than other people want to sell it, it goes up. It’s not about the number of buyers vs. seller (though you hear that, too - “there were more buyers than sellers” - False. There are always the exact same number of buyers and sellers, otherwise the transaction doesn’t happen), it’s about who is more desperate...and there were a lot of desperate sellers last week. As an example of how innocently this can all start - if John Q. Public sells his 100 shares of Apple stock one morning from his home office in his pajamas at $172 instead of $173, he just erased about $1 billion from the global financial system. Billion, with a “b”.
So, back to this week’s market action. Is it a dead cat bounce? Maybe, maybe not. Right now, it’s Schrodinger’s cat. Except instead of radioactive decay triggering the poisonous gas, it’s investor psychology and behavioral finance.
Did you ever do that thing in school where you had to drop an egg down a flight of stairs, and all you had to cushion its fall was something like duct tape, cardboard, and plastic lunch straws from the cafeteria? You try and protect it as best you can, and then you drop it and run down the stairs to see if the egg survived the fall? It’s the same kind of idea.
Nobody knows what the market is going to do next week. Not to be glib, but that’s what makes it a market. It could end the week at new all-time highs. Or it could go the way of the dead cat...if dead cats could keep falling through whatever surface they initially bounced off of. Either way, we’ll be there watching out for you!
Those of you versed in our strategy know we predominantly trade four major asset classes (US Large, US Small, International Developed, Emerging Markets) around the 200-day moving average. In a perfect world, we would see a weekly close above or below the 200-DMA to trigger a buy or sell signal.
Last Friday (2/9), Developed International and US Small both broke below their 200-DMA intraday. Given the speed of the decline and the history of the two 4+% down days that had already happened last week (Monday & Thursday), we didn’t wait for the close to verify a sell signal (as waiting for that would have necessitated selling on Monday, potentially down another 4+%), and so we sold part of the International Developed and US Small allocations last Friday.
As it turned out, US Large Caps touched their 200-DMA Friday afternoon and then, from pretty much that exact moment, everything across the board was bought for 5 straight days. Because of that midday bounce last Friday, everything closed the week above the 200-DMA, and so we remained fully invested in US Large and EM (and half invested in US Small and International Developed).
Given the positive market action this week, we expect to start reinvesting the cash back into the US Small and International Developed asset classes next week, bringing those up to their full allocation again...unless we open up Schrodinger’s box Tuesday morning after a long President’s Day weekend and find out, upon observation, that the cat is, in fact, dead.
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