Tuesday’s bounce almost certainly DOESN’T mean the turbulence is over. The lows and long-term uptrends have to be tested before that can happen
Dangerous Waves |
The market vocabulary for events like we’ve just witnessed is a tad distasteful. When prices rebound after a big fall, it’s referred to as a “dead cat bounce” because even a dead cat will rebound if you drop it far enough. Let’s instead look at an oceanographic metaphor to try to understand what’s happening; specifically, the science of tsunamis.
Tsunamis can produce unthinkable tragedies, such as around the Indian Ocean in 2004 and the Fukushima disaster in 2011. Very fortunately, most have little to no effect on humans. We aren’t, thankfully, looking at their impact here as much as their cause. A tsunami results from an undersea earthquake that displaces great amounts of water, which must then go somewhere before settling again. The dynamics are complicated, but the effect is as if someone has hit the bottom of a bath hard with a hammer. There will be shocks and a series of waves. To summarize, quoting the seismologist Eric Geist, the deeper the water where the fault breaks, the bigger the tsunami will be; the earthquake must “permanently move large areas of the seafloor up and down,” and longer and wider breaks mean bigger quakes and more potential destruction from large, powerful waves.
Similar dynamics apply to financial markets. The more profound the underlying economic damage proves to be, the higher the waves of selling, and the longer they’ll persist. Somehow, the tectonic plates of international finance have been shaken in the last month, as a sharp change of sentiment toward the US economy and a reversal in the Japanese carry trade combined with a run to the exit from big US tech stocks, which had become blatantly overcrowded. That will not cause one wave, but a series of them with brief intervals of deceptive calm.
History tells us to expect a quick trading bounce, so the rebound at this point tells us little. Once there’s been this big of a surge, the market can be expected to test its lows, and its long-term upward trend (shown in the charts by the 200-day moving average) before calm can break out again. Almost certainly, a further test lies ahead:
To put numbers to this, Harry Colvin of Longview Economics in London looked at 15 S&P 500 selloffs since 1978, in which the initial wave of selling brought the index down by at least 10% (which happened in Monday’s intraday trading). The likelihood of a retest of the initial lows was high. “In 13 of the 15 examples, a retest of the Wave One low occurred in a subsequent wave of selling (i.e., after a relief rally). The two exceptions were April 2012; and October 1997.”
Nicholas Colas of Datatrek International applies lessons from the VIX index of volatility. Since inception in 1990, its daily average close is 19.5. A VIX of 35.3 is two standard deviations above the mean, while 43.2 is three above. The VIX briefly touched 55.1 on Monday — a level it has previously reached only 0.8% of the time, during the greatest crises. By Tuesday’s close, it was back to 27.7, but after such a shift on the market seabed, we should expect more waves.
Going through history, Colas finds that without a specific catalyst (in the form of a major economic or financial event), “the VIX is telling us that we have time (4-6 weeks) before a genuine investable low is at hand.” There may be tradable rallies for those willing to try to exploit them. If there turn out to be greater problems with the economy, we can expect to wait much longer. Some major financial plates have been dislodged. What matters is whether they’ve been shifted permanently (meaning a recession). Either way, the propulsive energy won’t abate just yet.
Written by John Authers, Bloomberg News
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