Goodnight Stocks: Waiting For The Crash To Arrive

by: Eric Parnell, CFA

“And we would all go down together”

-Goodnight Saigon, Billy Joel

The skies are increasingly darkening over the stock market. Since peaking on October 28, stocks as measured by the S&P 500 (NYSEARCA:SPY) have declined by -7%. And on Monday, the S&P 500 broke decisively below several key support levels including previous resistance in the 1220 range and its 50-day moving average. Perhaps the pullback is due to the ongoing debt crisis in Europe. Perhaps instead it’s due to the continuing fallout from the collapse of MF Global (OTC:MFGLQ). Maybe it’s both. But regardless of the reason, the stock market now appears to be fading fast. And not even the typically strong Thanksgiving holiday week can momentarily stem the tide. Looking ahead, we are seeing a troubling culmination in investment markets that may be signaling that a full-blown crisis might soon be getting under way.

A lesson learned from the 2008 financial crisis is that the final stages before the final collapse is characterized by virtually all asset classes starting to go down together. This is most likely due to the fact that major financial institutions are increasingly pressed to sell liquid risk assets in an attempt to deleverage, raise cash and pad stressed balance sheets. What is troubling is that over the last few weeks, we are seeing the same patterns start to form that were witnessed in the final days before the 2008 crisis fully erupted and the stock market cascaded lower.

The following is a chart of the stock market as measured by the S&P 500 Index from September 12, 2008, just before the collapse of Lehman Brothers, to the market bottom on March 9, 2009. On this chart are also a variety of other major asset classes including Preferred Stocks (NYSEARCA:PFF), High Yield Bonds (NYSEARCA:HYG), Investment Grade Corporate Bonds (NYSEARCA:LQD), Long-Term U.S. Treasuries (NYSEARCA:TLT) and Gold (NYSEARCA:GLD). In most market environments, these six asset classes are generally well diversified from each other. But during crisis and extreme market stress like we saw in late 2008, the correlations on many of these asset classes all converged toward +1.

(Click charts to expand)

Several key takeaways can be drawn from the 2008 episode.

First, contrary to popular belief, the stock market did not plunge immediately following the collapse of Lehman Brothers. Instead, it was actually HIGHER five trading days after the Lehman failure and was only down -7% a full 13 trading days later on October 1. But that did not mean that alarm bells weren't sounding loudly along the way that a stock market collapse was imminent by the beginning of October. These signals came from the credit markets, as the Investment Grade Corporate Bonds, High Yield Bonds and Preferred Stocks were all down just as much if not more over this same initial time period.

Second, even the safe haven asset classes succumbed for a time once the early October liquidation got under way in earnest. After rising sharply initially, Gold was eventually pulled lower and ended up turning negative for a time in late October and early November before leveling out. And even defensive U.S. Treasuries chopped along for many weeks between positive and negative territory before finally spiking sharply higher in mid November.

So where do we stand in November 2011, versus the late 2008 / early 2009 episode? The following is a chart of the stock market as measured by the S&P 500 Index from October 28, 2011, just before the collapse of MF Global, through November 21. As mentioned at the beginning of the article, stocks are down -7% as measured by the S&P 500 Index after 17 trading days. While this decline is not extraordinary thus far, what is notable is the accompanying declines in Investment Grade Corporate Bonds, High Yield Bonds and Preferred Stocks. Although they are not necessarily leading on the way down as they did in 2008, they are trending meaningfully lower in their own right. And even Gold has fallen back into negative territory after initially spiking higher. The only major asset class that is bucking the trend so far is U.S. Treasuries, which have rallied +8% since late October. However, just as we saw with Gold back in 2008, even Treasuries might endure a short spell lower if underlying stress becomes sufficiently profound.

So what is an investor to do if another round of crisis is emerging? Of course, investors find it extremely difficult to keep a cool head and resist an itchy trigger finger in an environment marked by extreme stress and forced liquidation. But logical opportunities present themselves during such times of crisis, and investors can be rewarded for keeping a close watch and maintaining their discipline amid turmoil. For example, the liquidation sell-off in Gold and the grinding in Treasuries back in 2008 provided the opportunity for investors to acquire safe haven assets on the cheap when others were forced to sell. And once the Treasury Department recapitalized the banks and the Fed began aggressively working to reliquefy the financial system in an effort to prevent additional bank failures in early October 2008, the investment grade corporate bond market began to stabilize and started drifting higher once again.

It appears that we may be in the early stages of entering another such crisis phase over the next few months. We’ve been bracing for it for some time, and it may very well be that the time has finally come. If it does, it may get quite unsettling along the way. And the specific events behind the crisis will be different this time around. But by maintaining a level head and evaluating the situation as events unfold, it can present particularly attractive investment opportunities. While any such positions might struggle initially amid the turmoil, maintaining the disciplines of patience and resilience can be rewarded in such environments, particularly once the dust finally settles.

Disclosure: I am long GLD. I am long TIP and MBB. I had been long TLT until recently and may consider reinitiating long positions on pullbacks to its 50-day moving average.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.