"And in every one of these cycles of human life there will be one hour where, for the first time one man, and then many, will perceive the mighty thought of the eternal recurrence of all things"
F. Nietzsche, Thus Spoke Zarathustra
The theory on the recurrence of past events in the present and future is the very foundation of much financial analysis theory. Ubiquitous are concepts and methods such as mean reversion, back-testing, economic/debt/real estate/rate cycles, bubbles and busts, etc. But despite the general acknowledgement of these facts, the very timing of the occurrences appears nearly impossible. The vast majority of mathematical financial models attempting to unearth the exact timing of trends are, for instance, beset with the issue of regime-agnosticism, weighting the impact of particular risk factors the same throughout time although risk factor relevance has a tendency to wax and wane periodically (e.g., with time-varying risk premia).
The following analysis is a direct comparison of today's markets to Black Monday, drawing repeatedly from other economic and stock market cycles to determine relevance not just of particular risk factors in these two periods, but also their longevity and net effect in unison. The comparison results are staggering. In fact, this is intended to offer a perspective on why one can potentially time this particular market and take a position in a very low risk trade with favorable risk/return attributes.
The stock market crash of Oct. 19th, 1987, was the largest one day drop in history. The Dow lost 22.6% of value in one trading day - Black Monday. What preceded this unprecedented crash?
The prelude to 1987 and today:
- Blockbuster years - a multi-year bull market that seemed to have no upper bounds in sight. 1985 saw returns of 32.2% while 1986 saw returns of 18.5%. Does this seem familiar? In 2013, we see a return of 32.6%, while 2014 posted a similarly healthy return of 13.7%. In both cases, this was against the backdrop of a low growth, low inflation environment and accommodative FED policy.
- This multi-year bull market was fueled by none other than a trigger happy Volker cutting rates precipitously and forcing natural market activity to take a backseat to bubble formation.
- The reasons for the current bull market have a similar basis as the then new FED chair Bernanke implemented ZIRP. The stock market has undoubtedly been a beneficiary of this accommodation, this time around even more so than last fueled by the addition of QE. As displayed in the below Double Line chart, recent monetary policy effects on markets are obvious:
- But it wasn't Volker who presided over Black Monday it was a fresh face in office, Alan Greenspan.
- In this episode, we see a similar switch of the FED chair with Yellen taking the helm of the office. Why should this matter? Firstly, a new face will have a decidedly confusing effect on market expectations, causing uncertainty and market jitters - and to say the least - Yellen's FED has hitherto not abided by what markets expected of her, which brings us to the second part of the FED equation. The tightening of monetary conditions on markets.
- Alan Greenspan raised rates from 5.5 to 6 points in September, 1987. It took a while for markets to react to this surprise rate increase, but they did.
- Once again, there is a relevant parallel to today as sundry market participants hotly anticipate Yellen's first i-rate hike. Will markets repeat the mayhem? Whatever the case, one thing could exacerbate the current situation. While Alan Greenspan cut rates from 6% after the crash to tame markets, the current ZIRPolicy indicates that the markets do not have a "FED put" at their disposal, this could be interpreted as a great threat to a quick monetary response and further debase markets.
Looking beyond rate and monetary policy dynamics, we find interesting clues in other parts of the financial landscape.
- In 1986, markets saw oil prices drop by around 50% in a very short period of time. While this was anticipated to drive consumption and in turn growth, the leading indicator nature of this phenomenon wasn't apparent at the time.
- This year, we likewise saw a drop in oil of 60% and we read of the same rhetoric that this will drive consumption. However, against the backdrop of a weak economy and a low inflationary environment, what is the de facto relevant effect of this development? (My expectation is that it will cause the FED to reassess inflationary dynamics and hold off on raising rates, trumping market expectations once again). Furthermore, if we take a look at the most recent market crash in 2008, it was preceded by a decline in the price of oil from $148 to $30 per barrel. In other words, whatever the effect of cheap oil on the US economy, it seems to be a leading indicator of imminently unruly equity markets.
Equity market complex:
- Besides the obvious effect of accommodative monetary policy on equities, the US equity market rally since the Great Recession is partially explained by three intertwined factors:
o Corporate rationalization and productivity gains via technological advances, labor cuts and so forth, causing labor market slack (disinflationary). This is very finite; once tech systems have been updated these gains have largely run their course.
o EPS growth via broad-based stock buybacks. This is likewise window dressing and is neither associated with GDP growth nor is it sustainable. Furthermore, this expresses two great ills in the current economic environment: firstly, cash flush firms have no way of productively reinvesting their cash into the real economy, inhibiting organic corporate growth and thus GDP gains. Secondly, the precipitous increase in treasury stock is taking liquidity out of the equity market at noticeable levels and the volume declines that we have been seeing may very well be related to this.
o High M&A activity has likewise been a hallmark of the current market, YTD alone we have already reached a level of M&A activity that exceeds the high water mark set in 2007, before the Great Recession, and while nominally not nearly as high, this was also the case in the mid-1980s leading up to Black Monday.
- A large chunk of responsibility of the 1987 crash was tagged to so-called new-aged algorithmic trading methods that were both very sparsely tested and very sparsely understood.
- As of late, it has come to market participants' attention that algorithmic trading is having unexpected and at times "unfair" effects on market participants. This increases market uncertainty and could very well have an effect on an imminent sell off.
- In 1987, geopolitical developments in the Middle East saw increasing tensions between Iran and the US.
- In this cycle, we see a similar parallel with Russia intervening in a traditionally US-centric region of the world while ISIS (perhaps Iran backed) gains increasing influence.
- The "cleanest dirty shirt theory" according to which equity flows benefited greatly from the fact that no other asset class was offering a reasonable return has seen equity markets balloon to levels that are bubble-esque.
- In terms of market psychology, we furthermore see a meaningful generational shift. 2008 saw a lot of seasoned market participants lose their shirt, money, and ultimately their careers and a new batch of manager came in to fill the void. This generation thus far has ridden a bull market, posted positive returns and built a positive track record, recent market events have erased gains in a lot of equity and multi-asset funds YTD and none of these new managers are used to posting outright negative annual returns yet in their career. This is very precarious and will increase selling pressure if the market begins to correct again. Furthermore, in 1987, we see that two smaller market corrections preceded Black Monday. These were taken for granted as leading indicators, instead used as opportune moments to "buy dips" and cash in on profitable hedges that were set up after the first mini correction and gained value in the second mini correction. In 1987, a lot of these hedges were liquidated after the second correction and not reinstated - as the implied vol increase after the second correction made a hedge seem a bit too expensive in immediate historical terms.
- This could very well materialize today too - as markets have grown accustomed to very low levels of imp. vol
- While calendar timing is oftentimes derided as superstitious, further factors here point to possibly timing this market. Firstly, earnings season is coming up and against the backdrop of US dollar strength, we will see falling top-line revenue on a number of multinationals that have driven equity index revenue growth and profitability. In fact, the very industries that have driven profitability are the ones most heavily affected by an increased dollar and decreasing international sales, not to mention the havoc affecting Emerging Markets as of late, likely compounding the decrease in international sales.
All of these reasons in combination paint a very negative picture for equities currently and imply very little upside to equity markets at these levels with a potential black swan scenario of catastrophic proportions.
In conclusion, the following reasons are direct parallels to a highly unexpected market crash in 1987:
- Severe oil market correction
- FED policy uncertainty, new FED chair, potential FED Funds Rate increase
- Hot equity market that has defined a generation of investors and portfolio managers - plus mini equity market corrections that are putting the first potential negative year of returns on their radar
- Unsustainable equity market gains driven by the FED and financial engineering (share buybacks, M&A, rationalization)
- Middle East turmoil and increasing uncertainty in the region
- Algorithmic trading redefining accustomed price action and expectations
- Hedge fund positioning that is net short the market and slow money positioning that still has large positions in equities at risk of quick liquidation. The former are on to something, while the latter could greatly lose out.
One may counter that the FED will not raise rates in October and thus we'll be fine. However, the FED not raising rates actually increases market uncertainty and de facto implies a Dec rate hike based on prior FED statements. If the market expectations for a rate hike shift to December, then people will begin selling now due to the fact that December is such a low volume month, susceptible to greater realized volatility. This selling activity could adversely impact prices and cause many market participants to run for the hills. Conversely, if the FED does raise rates, we will likely also see an initial algo-driven correction followed by herd behavior type selling to lock in YTD performance among funds. It's a veritable catch 22.
Eliminate all beta from financial asset portfolios, fully hedge equity exposure or sell for cash (which is okay in this low inflationary environment). Furthermore, I recommend an equally weighted 3-7% position in far (40-50%) OTM put vol on equity indices, first and foremost the Nasdaq, as well as OTM call vol on the VIX 1st/2nd month contracts. Lastly, I advocate a position in OTM call vol on 1st/2nd month gold contracts. The rest of the portfolio should be held in cash or beta-neutralized. This limits possible losses to 3-7% and offers enormous potential upside in the case of a precipitous market correction, a very compelling risk/return (based on scenario analyses up to 7-1!). (Do note that since the '87 market crash, so-called "circuit breakers" have been introduced, so taking a bearish position on a highly correlated market to the SPX may be a more pragmatic approach to expressing this view.)
The bearish view on the SPX doesn't seem to be unique to me; hedge fund positioning data below seems to agree:
CFTC data for the week showed hedge fund capital moving across asset classes. In equities, large hedge funds increased their short positioning in the S&P 500 and Russell 2000, but bought NASDAQ 100 to a net long from a net short. The reading for the S&P 500 went back to a crowded short, with the highest short notional since Oct. 2011.
Additional disclosure: I am short the equity market and following my recommended trades as listed in this article.