How to handle the Flash Crash of 2018
by Raul Elizalde - 2018-02-06
After a meteoric rise, the stock market lost more than 6% in only two days. Why did this happen, and where do we go from here?
At the close of Monday, February 5 2018, the S&P 500 gave up more than all the year’s gains. Put in perspective this is not a large move: the index is roughly back to where it was just a couple of months before. Also, there are no clear fundamental reasons behind the decline: both the economy and corporate earnings are strong, unemployment is low, and the global economy is in good shape.
Some reasons behind the sharp fall are most likely technical, such as the high levels of margin debt, elevated P/E ratios, side-effects brought about by the purchase of insurance by some market participants, and so on. These kind of factors rarely portend a large, structural move to the downside.
There are, however, some fundamental weaknesses in the system. The most important is the enormous increase in private sector debt that both households and non-financial corporations have accumulated in the last few years. When and if interest rates rise too much or beyond a certain threshold, a much more serious credit-driven problem can materialize and evolve into a full-fledged crisis that could profoundly affect markets. The quick rise in interest rates last week may therefore have something to do with the stock market move, but we think that rates are not yet close to trigger widespread credit problems.
As we described in a recent newsletter, the recent tax cut is another reason for concern. This is because coming at a time of full employment it can cause the economy to overheat and inflation to climb, driving the Federal Reserve to tighten monetary policy. This could trigger the kind of credit crisis we fear.
Additionally, the tax cut is likely to create a large increase of public debt, which would limit options to fight the next inevitable recession and thus turn a normal deceleration of the economy into a more serious downturn.
We believe, however, that we are not yet at the edge of recession or a negative credit event. The swift market fall seems due, instead, to the kind of technical factors that we mentioned earlier. If so, it could be useful to explore what happened in similar situations in the past when stocks had technically-driven two- or three-day declines of more than 6-7%.
We looked at the history of the S&P 500 since its inception and we identified nine such instances, from the “Kennedy Slide” of 1962 to the China-driven volatility of August 2015. We did not include the Crash of 2008 because it was not a mere technical decline but the result of serious fundamental concerns about the viability of the banking system. While technical factors could have exacerbated the 2008-2009 market rout, they were clearly not the cause.
In all these instances we observed that after a few days, weeks or months the market recovered virtually all the lost ground. While the market fell more than 6% twice during the bear market of 2000-2003, it also found full relief soon after, even if it eventually resumed its downward march.
In conclusion, it seems that it rarely pays to sell immediately after a sharp two- or three-day move. Waiting for markets to stabilize instead appears to be a better strategy, because prices eventually tend to rebound even if they keep falling later on. This appears to be the case especially after climbing for a while, as can be seen in the charts of 1987, 1989, 1997, 1998, 2000, 2011 and 2015.
Even though we are concerned about the longer-term market outlook due to the stretched credit conditions, we think that investors who want to reduce their exposure to risk assets will not have to wait long before the market reaches a better point if they want to sell.
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