Early this year equities fell
by 10% in a matter of days even while the economy continued to improve. In the previous post I mentioned 8 “signposts” that would
help detect an approaching recession but these would have been of little help for predicting this market flash-crash because they are higher level indicators and do not track money
flows in real time. Market participants usually have a tendency to view the future as an
extrapolation of the current conditions, so if times are good it’s natural to
think that the bad times are in the distant the future rather than right around
the corner and vice versa. For this reason, many were caught by surprise.
So how can we protect our portfolios from seemingly random sell-offs
like this? Let’s begin by identifying some of the major warning signs. For the past 2 years the interest rates had been going up and accelerating
during the preceding 6 months. The FED had announced that it was on course
to raise interest rates further throughout the year. Market volatility had
been at all-time lows and traders had developed trading models that assumed
that volatility would remain low and when it spiked they flooded the market with sell orders to protect their capital. Finally,
before the market slide started there was unusually low liquidity which amplified
the crash.
Let’s assume you had taken note of the warning signs and had seen
this crash coming. Naturally the next thing you would have wanted to know is
when would the crash unfold. As you contemplated your next move you reasoned that if you closed your position you would
miss out on further price gains and if you stayed you took a heightened risk.
Unfortunately, it is impossible to predict a market turn with significant confidence. However, an investor could possibly have recognized the parabolic shape of price movement - which is often a sign of
irrational behavior - and reduced exposure. However, it often is too late to make adjustments to the portfolio and the staying power will be dictated by the risk profile of the portfolio - a major component of which is the price of entry of the position.
So what’s the takeaway of this article? Markets will always experience flash-crash events and we cannot predict them. But if one understands the current state of the economic business cycle and the long term leverage/deleverage cycle it will be easier to distinguish between a market dip that is temporary and could be used to gain more exposure or a dip that is better left alone to run its course.
What might cause the next major market correction? The main contributing
factor to the previous recession was excessive consumer debt. Since then, consumers have continued to deleverage and the
FED has mended the economy through quantitative easing and historically low interest rates. Unfortunately, the side effect of a prolonged low interest rate regime has been
that corporations have increased debt to record levels. This is troubling according to research done by Guggenheim Partners which has said that if short term rates cross over 3% we'll be faced with a new wave of corporate bond defaults and a very significant market correction - after all, the ratio of corporate profit to GDP is at levels not seen since the 1950s. If this prediction is true then it would mean that the FED has been creating a new market bubble while fighting another.
