Insights

Markets Take the Stairs up and the Elevator Down

By
Gabe Lembeck
February 14, 2018
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A common saying in finance is that “markets take the stairs up and the elevator down.” After more than 3,000 days of steady stair climbing and very little volatility, that changed violently and suddenly on Friday, February 2, and Monday, February 5, 2018.

Just how out of the ordinary was the market behavior over that two-day period?

Excluding the Great Depression, Friday and Monday combined was the 35th worst two consecutive days in the history of the S&P 500. That is the 35th worst two consecutive days in nearly 20,000 trading days.

The conclusion: While the stock market’s price action was extraordinary, it was not unprecedented. However, since we had not seen a day like Monday since 2009, many of us forgot what such a dramatic drop felt like.

It is important, then, in these times to view the market through a prism of historical experience, not personal experience.

So why did this particular episode happen? The usual suspects this time in the blame game were:

  1. Bitcoin,
  2. Interest rate trajectory/inflation concerns,
  3. Washington chaos, and
  4. Inverse and leveraged ETFs, notably XIV.

While there was likely some fallout from these potential causes, why did this particular episode REALLY happen? After two years with historically low volatility, investors will REALLY sell when they want to sell. Furthermore, as we discussed in our 2018 Capital Markets Forecast, skepticism has finally turned to optimism, and January saw a spate of new investors—including stock-market shy millennials—who finally entered the market. The volatility of last week saw many of those same, new investors exit quickly. This is fine.

As a general rule, markets take the stairs up and the elevator down. Historical precedence has demonstrated that the steeper and smoother the staircase, the swifter the elevator. While markets generally have exhibited minimal volatility during this bull market, there have been some elevators.

Figure 1: 16 Elevators Since 1982

[caption id="attachment_1029" align="alignnone" width="300"]

S&P 500 elevator performance graph

Source: FactSet[/caption]

Do not let the emotion of the moment drown out what the market has told us in the past. This is what our Tier 1 model aims to do: Take the emotion out of the decision and tell us what the market has historically done.

What history has shown us is that it is extremely rare for a bear market to start with this kind of move. Historically, these types of moves happen in the middle of bear markets or during a bull market as part of a consolidation. Monday’s midday plunge and modest recovery were likely margin calls and stop losses getting triggered. At this point, we do expect the market to continue to move higher when this all consolidates. Given the vastness of the drawdowns, however, it could take several months to repair.

Our key takeaways after this recent volatility are as follows:

  1. Erratic market behavior from time to time should be expected. The equity risk premium exists because we take a risk in owning equities. If equities had no risk, their return would be more like a risk-free Treasury bond.
  2. As a rule, such behavior is not the start of anything structurally problematic.
  3. Do not let the emotion of the moment drown out what the market has told us in the past. This is a theme worth repeating.
  4. Our Tier 1 model process will allow us to do this, thus taking what we “think” will happen out of the process. Because what we “think” will happen is far more subjective than objective.

Such drastic losses in the span of a few days are difficult for clients to swallow, especially after such a long period of calm in the markets. However, we encourage our clients to ignore the behavioral tendencies to react emotionally and instead pay attention to underlying, long-term fundamentals. For now, our long-term models continue to maintain their bullish signal, and we will keep a close eye and make any adjustments to portfolio allocations accordingly.

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