Balancing a 20% Decline in Indices

In a week that saw a clear softening in Fed rate hike rhetoric, some new China trade meetings planned, but no progress at all on the shutdown you might be forgiven for thinking it would be a surprisingly dull market following the previous two weeks. But traders are animated by debate over the next major move in equities and their corollary: US yields and the Dollar. The outcome, we believe, is best instructed by an historical perspective of the four possible market drivers (Fundamental, Intermarket Technical and Sentiment).

Indices have satisfied the fundamental milestones of a stock bull market and market sentiment has clearly been dented. And both the USD and yields have moved accordingly. And yet history shows at this juncture, sentiment is variable enough to allow a significant shift in stocks without substantially affecting other markets. This divergence between asset classes often drives a later technical reversal in many if not all markets. The purpose of today’s newsletter is to explain technically what US indices typically do after a 20% decline from new highs, the relationship between stocks bonds and the Dollar in such a move and whether that relationship sheds any light on what markets are likely to do over the next week and beyond. This is an important pillar to our Forex Index/Commodity and Stock Outlooks for 2019 to be sent to subscribers starting this week.

If the stock market had a glossary we would probably take issue with many of the entries. For example, the definition of a bear market – a decline of over 20% - is misleading, and often just plain wrong. A 20% decline in the right place of a trend can technically be very bullish, correct the preceding rally and set up the next large leg higher. 2011 is a good recent example of this.

But whether or not we agree with the terminology, the actual 20% figure is interesting as a 20% decline often leads to a bounce. The reason for this is not always clear. Perhaps lately it has become self-fulfilling and even counter-intuitive; just as the media reports a bear market and the man on the street gets scared, a sharp rally develops. Yet the original 20% figure seems to come from the declines from 1957-1973 where the SPX made five5 separate declines and always bounced around the -20% level.

Whatever the reason – this year’s recovery could also be attributed to the Santa Rally – what happens after the initial bounce is of paramount importance. We try to trade with the odds in our favour and when history tells us a certain outcome is high probability, we have to take note. On this particular occasion, history tells us that there has never been an occasion when the initial bounce does not fade and at least re-test the lows.

To be specific, there have been 12 occasions the SPX has declined over 20% from a fresh all-time high. As we can see, not all of the bounces from the -20% area have been significant, but every single bounce either reversed lower to continue the bear market, or reversed to test/poke the low. The bottom in 1990 actually made a two day bounce from -20% before declining into a marginal new low 3 days later (contrary to what is shown on the table above), but we will look at this and other examples in the charts shown detail later.

Again, the exact reasons why every bounce fades are not set in stone. We should really distinguish from the six occasions where price continued much lower in what can accurately be called a bear market, and the six times where a bottom was formed in the region of the initial -20% decline. We would speculate the latter happens to allow larger positions to be accumulated. A poke of the lows is particularly handy for strong hands to buy from those panicking and getting stopped out. Volume studies of the recent lows made in December show particularly low volume due to the Christmas break. Who was around to buy on Christmas night as the market started to rip is a moot point. But it is technically consistent with a recovery to the neckline following a low volume break of a Head and Shoulders and provides much needed definition to the structure of the current market.

Studying each of the 12 declines and comparing it to the recent structure may help tell us what to expect going forward in the bigger picture but has a clear near term prognosis either way.

The closest match structurally is from 1966 and this suggests a poke of the Christmas low followed by a large recovery.

Other comparisons are not quite as close, but are still instructive and could come to the fore in the weeks and months to come. While our focus is now on catching the swing lower, as we approach the bottom and our focus will shift to buying the re-test.

Obviously when the SPX falls 20% or more other markets are affected (or occasionally even the cause). US yields generally fall with the SPX as often there are concerns around growth or the economy driving the declines. However, whether the decline in yields leads the SPX fractionally or vice versa may give us some clues to the question of if we are in an extended bear market or near the bottom.

Yields led the SPX lower in 2000 and 2008, and with the benefit of hindsight we can say this was because the economy was in real trouble and the SPX was in an extended bear market. However, in 1987, 1990, and 1998, years when the market bottomed fairly quickly, the SPX led yields lower. This was could well be a function of equities influencing Fed policy as a bear market in stocks obviously makes rate rises difficult and may even prompt rate cuts. Arguably, as the Fed is responding to a correction in stocks and not serious economic problems (there was no recession in 1987 or 1998), lower yields creates the conditions for a strong stock rally. We can see similarities with today’s market; the SPX is again leading yields lower, and the Fed appears to be backing off. This suggests there will be a large bounce at some point as the first leg down is retraced.

The relation between the SPX and the US dollar is also quite consistent, if less immediate.

A US dollar decline makes sense given that yields are falling. This may not tell us much about the economy or the prospects for the SPX, but since the dollar almost always lags (2000 being the only exception) it does reveal some excellent trading opportunities. These come not only on the short side, but also help us catch longs as we can see the dollar bottoms after the SPX makes its ubiquitous re-test of the lows.

Our confidence in the near term outlook for most markets is founded on clear historical precedence and one that should provide the basis of effective trading strategies for the next quarter if not the next year.

 

Good Luck and Good Trading

 

Ed Matts, Founder & Andrew McElroy, Chief Stocks Analyst
Matrix Trade

 

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