In my last article from November 2015, I wrote about the August 2015 swoon in the S&P and how it may have been related to the magnitude and velocity of the drop in oil prices. I also recommended watching commodities (oil and copper), and suggested if they tanked again that the S&P 500 would likely follow. Well it turns out that oil and copper did in fact tank again and the S&P 500 experienced another frightening drop shortly thereafter. However, after watching the S&P 500 inexplicably retrace its losses for a second time, I'm left wondering whether there were other driving forces at work. I now believe that the action in oil and its recent correlation with the S&P 500 have served more as cover than an actual catalyst for the S&P 500 action. After evaluating the price movement in the S&P 500 against individual sectors, it's evident that each sell-off and subsequent recovery over the last couple of years has included heavy sector rotation.
Could one big, bold player be responsible for the market's recent fluctuations, using an aggressive portfolio grooming strategy and assisted by herd mentality? It's difficult to believe that a single entity could pull off a controlled 10%+ move down and back up in the largest equity market in the world, but I have to at least entertain the possibility in today's environment of technically-driven algorithmic trade automation. It's also possible that a number of large, sharp players are in consortium, forming the same conclusions and following the same playbook.
Here's the problem:
You have a huge position in a sector you no longer want to own in your current size. You need to divest and reallocate to other areas, but your position is too big and your actions will substantially move the markets. If you try to reallocate all at once or simply sell what you don't want and buy what you do over time, you are likely to have to sell at depressed prices and pay a premium to fully reallocate to your desired areas. There has to be a better way...
The playbook is straightforward:
1) You wait for a vulnerable time in the market. After a multi-year bull run, in a time with heavy-handed central banks, geopolitical tensions, instability in commodity prices and news media propaganda, there are opportunities aplenty. Note: extremely low interest/discount rates supporting a higher P/E multiplier give you extra flexibility, as it is impossible to precisely pin prices based on fundamental projections alone.
2) You sell aggressively and continually, starting with the sector/stocks you want to dump, but also including your other holdings in controlled doses. The size and timing have to be substantial and persistent enough to incite fear and to trigger others' selling. You rely on momentum traders and algorithms to pick up the trend and assist with the flushing. Your objectives are to obscure your intentions to reduce specific holdings in a broader wave of selling and to create sellers at lower prices for the assets you'd eventually like to buy.
3) You allow for the panic to reach a head and begin to snap up everything you need for your newly reallocated portfolio, leaving your dropped sector/stocks in the dust. Your buying momentum returns some stability to the market, allowing for your newly repurchased shares to appreciate as the momentum players follow your lead. For style points, you incorporate a secondary flush to create a double bottom pattern, inspiring bottom calls from market pundits and instilling confidence in buyers who come in after you.
This is of course an oversimplification of the actual strategy that would be required to pull this off. There would be implications and likely actions necessary in foreign markets and in other asset classes as well. However, it seems logical that a player of the size required to successfully execute this plan would have ties to all of those markets.
First, let's go over the clues that suggest some deliberate maneuvering. When comparing the S&P 500 technical patterns between the August 2015 sell-off and recovery and the January 2016 sell-off and recovery, they appear far too similar to have developed from independently natural and uncoordinated responses to fundamental or economic forces.
Note the following on the chart below:
1) The overall "W" pattern formation is strikingly similar.
2) The timing of the patterns is strikingly similar.
3) The action against key technical indicators, including major moving averages and Bollinger Bands, is basically identical.
It is extremely unlikely that this happened by coincidence!
Note that these maneuvers returned the broader S&P index close to prior levels. However, when comparing against individual sectors, the discrepancies are telling. In each case, one or more sectors have clearly been distributed while others have been accumulated.
I went back even earlier to sell-off/recovery patterns in 2014 and I see the same phenomenon. For example, the 2014 "Ebola Scare" sell-off appears to have been an excuse to liquidate energy holdings and accumulate biotech. Clearly, some market participants detected and acted on the early warning signs of the impending crash in oil.
The August 2015 sell-off appears to resolve in a liquidation of biotech, perhaps as that trade became too crowded, with reallocation to other growth stocks (see QQQ and AMZN for examples). As the Fed balked at raising rates for most of 2015, growth-oriented stocks proved more lucrative than once anticipated.
The most recent January liquidation and reallocation seem to have been aimed at pairing down growth stocks, liquidating financials, and rotating back into the energy/materials/industrial complex, basically unwinding some previous moves. This makes perfect sense after the Fed played their hand in December. The Fed showed they weren't afraid to move off zero and raise rates over time, which projects to tougher valuations for growth stocks going forward due to a higher discount rate. The FANG trade had also become an overcrowded safe haven. At the same time, the Fed was dovish, citing the broader challenges facing the global economy and suggesting that further rate increases would be gradual at best. This tempered the prospects for financials and bolstered the case for assets like gold. Finally, their confidence to raise rates at all suggested that a U.S. recession was not imminent, making the beaten down energy/materials/industrial complex more palatable for reinvestment.
The following examples provide evidence of sector-level accumulation and distribution coinciding with the timing of S&P 500 sell-off/recovery cycles.
Late 2014 examples...
August 2015 and January 2016 examples...
Based on timing, price levels and technical indicators, I'm guessing that the most recent maneuver is likely over or close to it. The key question is what happens next? For market technicians, such an aggressive sell-off and full retracement followed by another of the same magnitude and duration is highly unusual. Some technicians point to the recent sell-offs hurting the long-term (100 and 200 day) moving averages and see the market forming a rolling top. If the recent oscillation pattern in the shorter daily moving averages continues, the market is due to roll over again in the near future. This is certainly something to be aware of and look out for. However, other trend followers believe the strength of the recent recovery suggests continuation on to new highs. I'd like to suggest a third possibility where the market returns to a less manipulated state with less volatility and less trend; a period where market participants collectively digest what just happened.
Recent action in the VIX is one possible tell that the maneuvering is over and the market is due to return to a more natural and stable state, at least in the short term. Coinciding with the end of this recent cycle (approximately 5 weeks straight up to form the right wing of the "W"), the VIX dropped below an ascending baseline, with market makers' option pricing reflecting lower expected volatility in the future. The VIX will be important to observe over the coming weeks for hints on whether the volatility might return.
Here's a thought. If these sell-offs and recoveries are truly the result of coordinated portfolio reallocation, the maneuvers must be working well for those executing them because the same playbook has been reused. If it keeps working, it seems probable that similar tactics will remain in play for the future and it's a good idea to think about how to protect yourself and/or react the next time this happens. Unfortunately, the next legitimate downtrend may only be distinguishable from one of these controlled maneuvers in hindsight!
Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.