What Does History Tell Us?

End of Day Update:

The S&P500 opened with strong gains Tuesday morning following overnight stability in China, Europe, and the oil markets. But the comfort of a rebound was short-lived as we slid more than 30-points from the early highs. Only a late surge prevented us from closing deep in the red.

While a lot that could be said about Tuesday’s price-action, it has already been superseded by plunging S&P500 futures in Asia’s Wednesday morning trade. We don’t have to look far to find the usual suspect; oil slipped another 2.5% and is now under $28 for February delivery.

Counting this overnight weakness, we find ourselves down nearly 14% from last year’s highs. While this feels terrifying, where does this rate historically? Over the last 65-years the S&P500 has fallen more than 10% twenty-times, or about once every three-years. Losses of more than 15% occurred eleven-times, meaning nearly half of all 10% selloffs never made it past 15%. But if we pass 15%, things don’t look as rosy because nine-times we shot straight through 20%.

What does this historical data tell us? That selloffs between 10% and 15% tend to bounce while those that exceed 15% tend to keep going. While at first this phenomena seems perplexing, it actually makes sense when we look at the makeup of market participants.

We can segment stock owners into two groups, those that follow the market closely and those that don’t. Sentiment measures that include AAII, Stocktwits, option buyers and sellers, newsletter writers, and all the other popularly quoted sources tell us the opinions of active participants. These people tend to trade more frequently and drive daily market moves. A 10% selloff will push the sentiment of the active owners into the cellar where more often than not capitulation selling results in a rebound. But occasionally the panic and fear mongering achieves such intensity that Wall Street’s dirty laundry reaches Main Street. Losses above 15% is when we start waking up a whole new segment of owners and this larger supply allows the oversold condition to intensify. Currently we find ourselves just above this inflection point. Drop a few more percent and we risk Main Street joining in this circle-jerk selloff.

Does this mean current owners should get out now while they still have a chance? Not necessarily. It all depends on timeframe. Nimble day-traders and swing-traders who are good at spotting capitulation can profit from near-term weakness and the inevitable rebound, but most everyone else should be thinking about buying this dip, not selling it. The other thing that history tells us is only three of the nine 20%+ selloffs were under 20% for more than a few weeks or months. While we sliced through 20%, we bounced back nearly as quickly six out of the nine-times. The odds are clearly more in favor of buying these discounts than selling them.

But what about those other three-times? I suppose each of us must decide of this oil weakness is a one-in-twenty selloff that completely trashes our financial system. We saw prolonged losses from the 1970’s stagflation and oil embargo. Then there was the grossly overheated tech bubble that came crashing down. And lastly the housing bubble where the most valuable asset people owned plunged in value. If you think a slowing China and falling oil prices ranks up there with the worst financial calamities of the last 65-years, then you should be selling. But if you have a less fatalistic view of the world and our economy, then this is just another buyable dip on our way higher.

While it is never easy to hold through volatility, the time to sell was when the first cracks started forming, not now that we are approaching a capitulation. I told my subscribers on January 4th that the price-action was deteriorating and I moved to cash. Now a couple of weeks later I’m on the verge of buying this weakness. If people want to sell me stock at a steep discount, I’m more than happy to oblige them. Their loss is my gain.

Jani

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