by Neil Azous, Chief Investment Officer
- Our Stock Market Correction Framework
- All Corrections
- Type 1 – Correction
- Type 2 – Correction
- Current Correction
- “A Different Strain”
- What Else You Need To Know
- Other Frameworks
Here is what we published on February 18, 2020: Coronavirus To Trigger Fed To Declare Force Majeure On Rate Pause
Our view is materializing in real-time.
Our Stock Market Correction Framework
Our working framework for S&P 500 corrections is below.
Firstly, we integrate moving averages into the framework. We view:
- The 200-day moving average (DMAVG) as a short-term trend change;
- The 55-week moving average (WMAVG) as a medium-term trend change;
- The 200-week moving average (WMAVG) as a cycle change.
There are two types of corrections:
- Type 1: A 7-12% drawdown where the SPX trades below the 200-DMAVG for less than two weeks.
- 2. Type 2: A 14-21% drawdown where the SPX trades below the 200-DMAVG for 30-90 days.
The common denominator for the transition to Type 2 from Type 1 is the 55-week MAVG.
Currently, we are on the cusp of transitioning to Type 2 – a deeper and prolonged correction.
Including the current one, there have been 27 corrections greater than 5% since the March 2009 global financial crisis low.
The table below shows you the correction period, the SPX Index high-low, percentage decline, the number of calendar days the decline lasted, and the reason for why stocks fell.
Type 1 – Correction
Of the 27 corrections, 21 of them fall into Type 1.
The table below shows the average drawdown is -7.6%.
This type of correction has nothing in common. It is usually confined to short-term events, including a US government shutdown, country rating downgrades, growth scare (different than a contraction), or a large and fast move in a key asset, such as the US dollar or crude oil.
Common Denominator: None.
Type 2 – Correction
Of the 27 corrections, 5 of them fall into Type 2.
The table below shows the average drawdown is -17.2%.
Unlike Type 1, Type 2 corrections have one thing in common – that is, the event is a “heart attack.” Historically, it is the result of a Federal Reserve hiking cycle, Chinese yuan devaluation, Eurozone crisis, or the start of a growth contraction that leads to a recession.
Common Denominator: The SPX recorded two “weekly” closes below the 55-WMAVG in all instances.
The magnitude of the drawdown is between the ranges recorded for Type 1 (i.e., -7% to -12%) and Type 2 (i.e., -14% to -21%).
As of last night’s close, the peak-to-trough drawdown is -12.2%.
On an intra-day basis today, as of 12:00 p.m. EST, the peak-to-trough drawdown is -15.8%.
The SPX Index closed below the 55-WMAVG yesterday. It is likely to confirm it today on the “weekly” close.
This would be a potentially significant development as the 55-WMAVG is the common denominator in all transitions to a Type 2 from Type 1 correction.
The potential trap is that if it confirms a close below the 55-WMAVG today on a “weekly” close, it still must confirm it next Friday as well. Otherwise, it would ultimately fall into a Type 1 correction.
“A Different Strain”
The speed in which this correction is unfolding is unprecedented.
For example, the correction in the stock market over the past six trading sessions is the fastest 10% decline in the S&P500 from a record high. The speed of the decline over the past week is even swifter than during the “Black Monday” episode in October 1987, where the peak was in August 1987. Also, the only other time the benchmark index fell 10% in six trading days from an all-time high was December 1928.
In the spirit of the Coronavirus causing this correction, that is why we label it “a different strain.”
What Else You Need To Know
The weekly close today below the 55-WMAVG, if it materializes, is very important. At the time of this writing, the VIX, aka “fear index,” is over 45. In this extremely high volatility regime, the result could go either way today.
Historically, as you can see in the above tables, more often than not, if that moving average is confirmed, the sell-off tends to end much lower, near the 200-WAMVG, and is much more protracted in time.
Simultaneously, other asset classes fall. This is especially true if credit and/or crude oil are involved. Why? Because there is no hedge to lower real interest rates, wider credit spreads, and the barrel falling simultaneously, period. This causes a “VaR shock” to investment models as volatility is too hard to control. The only remedy is to reduce risk.
Secondly, when a correction to Type 2 from Type 1 is transitioning, outside of a 1-5-day “tactical” trade, it is a mistake to rely on indicators in isolation: put/call ratio, sentiment, VIX curve inversion, technicals, positioning, etc. Why? Because 1-2 days before the 200-WMAVG is confirmed, all of these indicators at once make ”all-time” or test ”all-time” record levels. Said differently, if you rely on one indicator or try to backfit a reason to buy weakness by fusing a couple together, and are wrong, the 200-WMAVG is 2632, which is another -11% down.
The key point overall is that the market is trying to decide if this Coronavirus is the equivalent of a “heart attack” as described in Type 2 corrections.
Because the virus is an “unknown unknown” and Bernie Sanders could take a decisive lead following Super Tuesday on March 3rd, two trading days from now, the market is leaning towards a Type 2 correction, i.e., a continuation of weakness.
The saving grace now is whether the Federal Reserve will decisively cut interest rates before the mid-March FOMC meeting.
Currently, the interest rate market is pricing in a high probability of an imminent emergency cut. More candidly, fixed income is demanding one.
For example, a 25 basis point cut at the March FOMC meeting probability reached as high as ~150% today, which includes the “trinomial probability” of a 66% chance of a 50 bps cut.
An emergency intra-meeting 25 basis point rate cut reached a 50-60% probability today, up from 15% yesterday. Historically, once we cross the 30-40% threshold this close to the upcoming FOMC meeting, there is no looking back.
The key point here is that investors have moved on to concern over funding and credit market stress. This is important to recognize because this is the delineation that induces the Fed to act, not the pedestrian view of a stock market correction.
The new issuance market for US investment-grade credit has been shut since last week. Corporate Treasurers are concerned over a lengthier closure reminiscent of Q4 2018, which lasted seven weeks.
Various other measures that we track closely (not illustrated here for brevity) in the short-term interest rate (STIR) or funding markets are seeing measurable spread widening, especially in LIBOR-based products as the cost of funds and counterparty risk is increasing at a rapid pace.
Ahead of the mid-March FOMC meeting, the Fed enters their “blackout” period next Friday – verbal guidance that a cut is imminent has not yet been communicated. That should not make a difference. As we have said repeatably over the last 18 months, in an easing cycle, the market forces the Fed’s hand. In a hiking cycle, it is the other way around.
There is a framework beyond these tables if a recession materializes. The above framework only includes the post-GFC era, where a recession has not occurred. Meaning, the downside is not limited to -21% if the Coronavirus growth contraction leads to a recession.
Conversely, there is a framework for a recovery process depending on whether this ultimately is a Type 1 or Type 2 correction. There is a big difference between the time it takes to recover (i.e., days/weeks vs. months) depending on the Type of correction.
As the outcome unfolds – Type 1, Type 2, Recession, or Recovery – we will update this framework accordingly along the way.
If you are interested in learning more about how we manage equity risk during market corrections, please call us at 203-539-6067 or email us at email@example.com.
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