Our Autumn Of Discontent

Includes: DIA, SPY
by: Salil Mehta

It is the elusive market drop that we have been waiting for all year: Each month, from May through August, we anticipated what would finally be a 10% or greater market correction. Or an outright crash, given the known tapering later this year of the Federal Reserve's quantitative easing. My previous articles (see here for one example) have noted that we should expect a downturn from this engineered market recovery, before later having a recovery rally. But for now we must focus on the risks ahead. And in this article we will examine the worst 1% of market crashes throughout history, with a clear conclusion to still not be in U.S. equities.

To be sure, as it was reinforced in my Seeking Alpha Instablog on Aug. 2, we have now seen a significant top for the year, and we will see more downward grinding going forward. Soon we will approach the fall months, and we all suspect that these are some of the riskiest months in the market. After all, most of the 10 worst one-day market panics in the Dow have infamously occurred near October. But a ranked listing of only 10 is a very small sample of extreme events from which to draw any statistical significance.

The history of the Dow goes back to the late-19th century. And with enough data we can better understand the frequency of when severe market drops occur. Mark Twain once said at about the same time the Dow was created that "it is not worth while to try to keep history from repeating itself, for man's character will always make the preventing of the repetitions impossible."

In this article I will show that there is a statistically strong historical repetition of market crashes occurring in the months near October. But so, too, do crashes more often occur on Mondays in any month of the year. Of the 29,400 trading days in the history of the Dow, I looked at the worst 294 (or 1%) of them. In order to qualify for this club of the worst 1% days, a daily price drop of at least 3.2% was needed. And while this works out to a pace of five of these worst 1% days biennially, the most recent one was November 2011. So when the collapse comes it will be huge, and not worth the risk/reward of staying in in equities for the near term.

Here is the distribution of those 294 days by month, in red on the chart. As a statistical alternate, I also show in light green the distribution of 294 days evenly spread across 12 months.

Click to enlarge images.

Next is the distribution of these worst 1% trading days, shown by the weekday when they occurred. The statistical strength of Mondays is very powerful, and it does not transfer over to either the trading day before or after (e.g., Fridays or Tuesdays). We can see this with a simple kernalized smoothing technique, with a width of plus or minus one day. We see the kernalized distribution essentially matches the uniform distribution in light green, so we fail to appreciate that the Mondays result is a product of luck in the five-weekdays cycle.

On the contrary, a similar smoothing exercise in the monthly distribution data above wouldn't have changed the monthly seasonal pattern we see. Additionally, we know that there are two weekend, non-trading days, breaking the psychological rhythm between Friday and Monday. There is no similar large break, of any non-trading months, in the monthly distribution.

It is worth noting that the combinations of the weekday and monthly data are also statistically significant. Again, here I used a Chi-square non-parametric test to measure possible differences from expectations. With the 294 worst trading days, spread over 60 weekday and month combinations, I have designed a statistically large enough sample to see significance within the weekday and month combination.

We see this 60 weekday and month combination distribution above. October is represented in yellow; Monday is represented by blue. We see that the riskiest time for the markets, shown in green, have been near October, and particularly on Mondays.

None of the above analysis is statistically significant for the average severity of market drops, beyond the 3.2% threshold just to be in this worst 1% club. But as I have shown here, it is important to also pay attention to the frequency of highly risky market times when thinking about the choppy autumnal season ahead. The best mechanism to execute these ideas continues to be going short the U.S. stock market, starting on Aug. 2 and remaining short at this time. Or selling out-of-the-money call options on the equity indices. What was seen yesterday, on Aug. 27, is a foreshadowing of more downward shocks that will threaten much of the gains made in the U.S. stock market year to date.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.