What Does History Tell Us?

By Jani Ziedins | End of Day Analysis

Jan 19

Screen Shot 2016-01-19 at 11.06.28 PMEnd 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While a lot that could be said about Tuesday’s price-action, it has already been superseded by plunging S&P500 futures in Asia’s Wednesday morning trade.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.

Screen Shot 2016-01-19 at 11.06.40 PMBut 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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About the Author

Jani Ziedins (pronounced Ya-nee) is a full-time investor and writer who has successfully traded stocks and options for more than a decade. He earned a B.S. in Mechanical Engineering from the Colorado School of Mines and an MBA and M.S. Marketing from the University of Colorado Denver. His prior professional experience includes manufacturing engineering at Fortune 500 companies, structural engineering, small business consultant, collegiate instructor, and managing investment real estate. He is now fortunate enough to trade full-time from home, affording him the luxury of spending extra time with his wife and two young children.

Investrite January 20, 2016

Right on Jani, I have been buying though in small increments. On selective companies only, nothing broad just yet. Your understanding of the flows and the averages is keen. Just take it easy, the world is not ending, China is transferring to a different gdp income, from manufacturing to their own population as buyers, oil is doing what it needs to do. there is more oil than the world can handle. India looks like a place to slowly dip into. Just some broad thoughts as I keep adding to positions. I like IBM, AAPL, COP, ITC and a few others.

    Jani Ziedins January 20, 2016

    That is a great approach. Stay calm while others fear a falling sky.

Tom A January 20, 2016

But what if this is a repricing of risk, due to the exit of the Fed Put? What is forward PEs are being repriced from 18 to their historical average of 12? Add to that falling profits and you get to 1400 on the S&P very quickly. That would be fine, but what if we got there and stayed there for a year or two?

    Jani Ziedins January 20, 2016

    Anything is possible. But major bear markets are typically driven by recessions, not repricing of risk. I suspect this secular bull market will die when our economy overheats and most would agree we are nowhere near overheated levels. Dips are part of every move higher and this one reminds me a lot of 1998’s Asian currency crisis. We all know what happened next. While we might not have hit bottom yet, it will take more than China and oil to take down our economy.

      Tom A January 21, 2016

      It is generally correct that bull markets end when economies overheat, because central banks step in to cool it down. But the chance of our economy overheating any time soon is ???. There is a possibility me might see another crisis like 2008 before we see the economy overheating. If that happens, do you think the bull market might continue unmindful of that? I am hoping this does not happen, but in this game you have to keep all options open. But, in my opinion, when the market falls apprx 19-20% from the highs, the Fed will immediately announce QE4 (as they will not be able to stomach any more pain than that), which will lead to a fierce rally for a couple of months. The interesting thing will be to watch what happens after that. If the economy continues to deteriorate, it is probably lights out for wall street, main street and the Fed, as the game that started in 2009 is over.

        Jani Ziedins January 21, 2016

        Loan defaults due to a decline in home prices did far more damage to our financial system than falling energy prices or a weak export sector ever could. We are an oil consuming, import fueled economy that will ultimately benefit from these developments.

        Most likely the “next 2008” is another 15 years away. If I had to guess, we are in the late 80s and have another decade of gains before the next debilitating financial crisis. The seventies was our last “lost decade” and that was followed by a 20-year secular bull market. We had dips, corrections, bear markets, and the largest single-day selloff in stock market history during that period, but every dip was buyable until the 2000 peak.

        Personally I think our Fed is done tinkering with QE no matter what the equity market does. 20% selloff are normal and healthy. But I do think QE worked really well and is now another arrow in the Fed’s quiver that will help us recover from the next crisis. Europe is only now waking up to this after their failed austerity left their economy miles behind the U.S.

        Maybe this selloff breaches the 20% threshold, but because we are still in a secular bull market, these losses will be erased within a year, if not sooner.

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