Most Important 48 Hours of 2018

Make or Break

The next 48 hours could well define the next three to six months. The 1987 style stock market Crash or at least the dress rehearsal. History is repeating itself in more ways than one. The issue simply is which month in 1987 it is repeating: April or October. In other words, a massive inflection point. Is the market about to fall off the cliff or about to commence the fiercest rally yet.. before the crash. The difference amounts to a 65% return within 6 months probably much sooner. Get it right and we make a fortune. Get it wrong and we can still make a slightly smaller fortune. The aim of today’s newsletter and particularly the appendix for subscribers is to assess the probabilities and therefore the trading strategies that can maximize opportunity and minimize risk.

In a week where the US raised rates an 8 week fragile stock market  and a year long weak Dollar both fell following both FOMC fractals and the rate hike in March 2017.

This nervousness was reflected by a strong safe haven rally in Gold which also followed last year’s rate hike, in line then with previous market jitters. Nothing out of the ordinary except Gold continues to follow the 1987 template closely as evidenced in our analysis pages.

But … we are now in a protectionist phase with potentially significant economic and geopolitical consequences – as we were in April 1987. Any attempt by the markets to recover this last week was soon scuppered by Trump introducing tariffs on intellectual property aimed directly at China. This duly prompted noises of retaliation from the largest holder of US bonds. The Chinese A50 fell 51.5%.

But…remember the market recovered after the Steel and Aluminum tariffs. The last nail in the coffin was the resignation of the National Security Adviser            H R McMaster. The list of departures from the US administration is becoming an embarrassment.

Even though this seems a long list, all Presidents suffer a surprisingly high turnover of key staff. 1987 saw White House Chief of Staff Regan resign in  February; Advisor Wallison in March; Henkel, Reagan’s Assistant in September, National Security Advisor Carlucci in November and even Senator Ron Paul resigned from the Republican Party in September. This was also the latter stages of the Iran-Contra affair. And yet the stock market uptrend survived…at least until October 1987.

What is at stake is simple and dramatic.  Just as in 1987, the market has now reached the largest inflection point possibly in a decade…39 days after the top.

We have a clear bias but we also have clear indicators not just in the DJIA and SPX but a whole host of other markets. This weekend, for subscribers,  we are publishing MAJOR INFLECTION a probability assessment of all instruments that we follow and have a correlation to stocks at such a critical juncture: crash or correction.

The 1987 crash was triggered by a number of factors. Stocks had been ramping taking PE valuations to excessive levels as they are now. And yet the Dollar entered the final leg of its downtrend while yields and commodities were rising. And clearly sentiment was extreme as it has been. Technically the market broke an almost identical triangle to the downside entering a series of ‘air pockets’. An air pocket is where the market cannot find an equilibrium so continues to gap down because there are not enough buyers to absorb the extreme panic liquidations. (See Edgar Peters’ Fractal Market Hypothesis for one of the best explanation of price movement). The May 2010 Flash crash and a notable absence of equilibria exemplified this well. This subsequently led to the encouragement of HFTs and the like to provide continual liquidity to avoid a recurrence of the air pockets. Can they stop a crash? No. They can provide more bids to be hit to make the decline more orderly. But the growth of the VIX market and potential liquidation of short volatility positions suggests firstly it will not be stopped and secondly air pockets and therefore gaps are more likely to occur outside NYSE trading hours.

This week was Jay Powell’s first meeting as Chairman of the Federal Reserve Board. There are some analogies also to 1987. Is it mere coincidence that his Senate confirmation preceded the 2018 top (so far) by 3 days when Alan Greenspan’s confirmation was only 12 days before the 1987 top? Yes and no. Since 1977, the Fed has operated under a “dual mandate” from Congress to foster economic conditions that achieve both stable prices and maximum sustainable employment. It is therefore charged with moderating long-term interest rates to achieve that stability and, by implication, maintain the original aim from its creation in December 1913  of a “safe, flexible and stable monetary and financial system.” Since 2009 its role has been expanded to supervise and regulate the banking sector to ensure that system remains stable and not undermined again – as it was in the sub-prime crisis of 2008. Such stability implies a relatively smooth transition from one chair to another and that any discontinuity or sudden shift will reflect a change in the underlying conditions.  Even though the innovation of QE has distorted historical comparison of this period to any previous, the current tightening regime is not dissimilar to the second half of the 1980s. Both Powell and Greenspan have been regarded as more hawkish than their predecessors even though the present Chair is yet to prove this.

The relatively fast series of rate rises in a similar period of disinflationary growth in 1987 was one of, if not the primary, cause of the crash. So even though Mr Powell said there is still ‘no sense in the data that we are at the cusp of an acceleration in inflation’ the rate rises and dot plots are relatively aggressive. This similarity is also borne out by some surprising closeness of some current markets to the average performance through a Chairmanship.

Stock market performance under different chairs has been mixed.

However, there is a noticeable drop generally in the index in the first 80 days of a chairman’s term before an, on average, strong recovery – although in this case it appears the current is front-running the average.

Gold also shows a mixed performance.

And again there is a similarity to the average which is driven strongly by the Dollar devaluation Gold rally under Volcker.

Although the Dollar also shows a varied distribution under different chairs….

… the current similarity of the current Dollar market to its average since 1930 is striking.and clearly suggests the final fateful decline in the USD is not far away.

Fractals perform best where they are measuring the main drivers of the market. It is difficult therefore to see how a Fed Chair could possibly make more difference than the often globally inspired variables they are supposed to be influencing. Averages suggest they can.

However, we very much doubt that Jay Powell will be able to prevent the potentially historic events of 2018—whenever it falls. One thing for sure, the next 48 hours are unlikely to be average.

Here’s to making the very best.

Good Luck

Ed Matts
Matrix Trade