When The Bough Breaks

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Includes: SPY
by: Eric Parnell, CFA

Summary

The U.S. stock market is showing signs of restlessness.

What exactly is it likely to look like once the bough finally breaks on the U.S. stock market?

And how much time, if any, will investors have to respond?

The U.S. stock market is showing signs of restlessness. Price volatility has started to come back to life over the past two years following a long liquidity-drunk post-crisis stretch where they hardly suffered a scratch. With stocks currently running at historically high valuations in the midst of what is already by some measures the second longest bull market in history, many investors are finding themselves increasingly bracing for the day when they finally wake up to find markets tumbling into in the midst of the next major downturn. Some even question whether such a day could come on Friday if the "Brexit" vote turns out differently than expected. Given the inevitability that we will someday have another bear market coupled with the possibility that it could be getting underway soon (if we're not actually already 14 months into it), what exactly is it likely to look like once the bough finally breaks on the U.S. stock market? And how much time, if any, will investors have to respond?

Learning From The Placidity Of The Post-Crisis Period

Stock market pullbacks have been few and far between during the post crisis period. That is, of course, until more recently.

The following is a list of post-crisis stock market pullbacks on a daily closing basis on the S&P 500 Index (NYSEARCA:SPY).

Several observations can be derived from this information.

First, both the magnitude and duration of these relatively infrequent stock market corrections were decreasing over time, the further the stocks distanced themselves from the March 2009 lows, as confidence built that either sustainably strong economic growth would arrive or the Fed would provide even more monetary generosity to support the economy and markets.

Although the initial periodic corrections in the years immediately following the financial crisis were a bit sharper, they were still fairly short lived with manageable declines that were followed by equally swift rallies that sent stocks to new post-crisis highs.

Eventually, this gave way to pullbacks that became only once to twice a year on average and were as short as a few trading weeks in some instances with declines that did not even exceed -10%.

By the end of 2014, it had gotten to the point where a -7% pullback on the S&P 500 Index over the course of a month felt so intolerable to many stock investors and the monetary policy makers that love them so much called for the verbal intervention of a regional bank president to perk the markets back up again.

The temperament of the market started to change, the further the Fed's final QE3 asset purchase stimulus program moved into the rear-view mirror. The pullbacks started to become longer, and the declines a bit deeper.

But have the two corrections over the past 18 months truly been that much longer or any more violent? A closer look reveals that they have been more the result of short but sharp shocks than sustained declines.

A Still Effective But Increasingly Less Comforting Stock Market Salve

So what has stemmed the decline during virtually all of these stock market pullbacks during the post crisis period? A U.S. Federal Reserve that comes running to the rescue either verbally or with monetary policy actions to help reassure stock investors that everything is going to be all right.

The fact that the Fed has stepped in so many times now provides us with a pattern of behavior from both a duration and magnitude of correction standpoint. Basically, what the Fed's actions surrounding past market pullbacks indicate is that it can tolerate a market decline lasting no more than either four weeks or falling by around -7% on average before it is inclined to intervene with either verbal support or policy action.

In the first many years following the financial crisis, this Fed support was enough to quickly snap the market out of it and propel it to new all-time highs.

But over the past two years, since the end of the Fed's last big stimulus program in QE3 and began entertaining the idea of raising rates, it has proven increasingly less effective. Gone are the catapulting bounces to new all-time highs. In their place have come smaller bounces matched by equally sized corrections.

As a result, what once used to push the stock market to new highs now only keeps the market in a sideways trading range.

Eventually, the next step in this evolution is likely to be the following, where the magnitude and duration of the declines start to exceed those of the rallies. In fact, it could be argued that we are already starting to see this phenomenon manifest itself in the S&P 500 since last summer with lower highs and a lower low along the way. Of course, if stocks are able to push to new highs in the coming weeks, that would come as a welcome offset for the bulls.

The Key Takeaways

Stock market volatility has picked up. And a new bear market is going to arrive someday if it isn't already underway. But this does not mean that investors need to exit the stock market in advance of the downturn to protect themselves from such an outcome.

Instead, the market has formed a pattern, thanks to the actions of the U.S. Federal Reserve. Is the future repeat of this pattern likely to make the next bear market a lot longer than it might otherwise be? Sure, but investors can use this fact to their advantage, particularly in the early stages of the next bear.

The probability is high that we are likely to see more sharp corrections in the S&P 500 Index going forward. But the best strategy in such a circumstance is not to panic. For investors can now reasonably expect that any correction lasting as long as four weeks with a decline anywhere in excess of -7% will be too much for the Fed to resist in wanting to intervene. And while the market response to the Fed may not be immediate, seven years of post-crisis history have shown that it will eventually get the message and bounce. Gone may be the days where your patience is rewarded by getting more than your money back from the broader stock market. But the continued power of the Fed should help ensure that you get enough of a bounce to exit the positions you otherwise wish you had gotten out of before the pullback having recovered a reasonable percentage of your value if not all of it.

As mentioned above, if the current long-term trend continues, the bounces will likely become less and the pullbacks more with the passage of time.

With this in mind, those investors that found themselves stunned and panicked following the sharp stock market pullbacks last summer and early this year may be well served to consider their current allocations with the S&P 500 Index once again grinding back at the top end of its two-year trading range. Put more directly, if you desperately wanted to sell back in August or February but didn't, now may be the time to think about it, particularly if any post "Brexit" vote enthusiasm has markets floating toward new all-time highs.

On the other hand, the more aggressive investors among us might seek to capitalize on these oscillating patterns both to the upside and the downside as they potentially increase in the days, weeks and months ahead.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

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.