In Conditions Like These, You Don’t Need Fear to See a Big Market Decline

By: Justice Clark Litle

Sep 17, 2020 | Investing Strategies

We recently explained why stocks could retest the March lows before the year is out. This made some readers upset.

Some of the feedback we received was along the lines of, “There is no way we could revisit the fear of the March lows.” The idea of replicating the fear conditions that existed in March seems impossible.

To which we say, yes and no. It is a bit more complicated than that.  

First off, as we said when explaining the scenario, a test of the March lows is “not the base case.” This means it is something that could happen — but not something that necessarily will happen. The point was that it could.

As Elroy Dimson once said, “risk means more things can happen than will happen.”

There are scenarios that could reasonably occur, which will never actually take place — and in the name of risk management, we want to be aware of those possibilities.

It is somewhat like buying hurricane insurance for your beach house. Hopefully the hurricane never shows up — and buying insurance doesn’t mean you expect it to. But having awareness, and being proactive, is good risk management. Then, too, big market declines don’t have to be based in fear. Sometimes they can occur with no fearfulness at all. At other times, the fear is like an avalanche — the fear unleashes a small move, but then other things trigger that cause a much larger move.

In our view, this also describes what happened in March 2020. The violent decline that started in late February was triggered by the pandemic, but the severity of the decline was caused by market structure. 

Traders have a term for large declines and crashes that are driven by something other than fundamentals or investor emotions. They are “market structure events.”

The mother of all market structure events was the Crash of 1987.

The crash of 1987 seemed to come out of the blue. It wasn’t really based on investor sentiment, or what was happening with international trade, or what Treasury Secretary James Baker said on TV (though all those things were blamed).

Paul Tudor Jones, a legendary hedge fund manager who made hundreds of millions in the 1987 crash — and hundreds of millions yet again three years later, in the Nikkei crash of 1990 — described the 1987 crash as an “embedded derivatives accident” due to a concept known as portfolio insurance.

Portfolio insurance was a hot concept among institutional investors in the late 1980s. The idea was that, if the market started to decline, you could hedge the risk in your long equity portfolio by selling S&P 500 futures against it.

The problem with portfolio insurance was that, the more the market declined, the greater the number of S&P 500 futures contracts the client had to sell.

This was fine if, say, a handful of institutions used portfolio insurance. But when a critical mass of them used it, the “hedge” became a self-fulfilling prophecy.

In the crash of 1987, because of portfolio insurance, a modest market decline created a cascading feedback loop, in which each tick downward triggered even more selling of S&P 500 futures contracts, which added more selling pressure in a vicious cycle.

The reason we are fearful of a crash-type market structure event in the last few months of 2020 — and the reason we described a “retest of the lows” scenario — is because the amount of distortion created by frenzied call-option buying feels beyond extreme.

It has gotten so intense that Wall Street hedge funds and high frequency trading firms are becoming obsessed with retail trader buy-and-sell data, and scraping keywords from retail trader chat rooms and message boards, in an effort to get the jump on what the Robinhood crowd buys next.

When behavior gets this lopsided and distorted, to the point where a critical mass of tech stocks are trading far beyond rational levels, you don’t need an outbreak of panic to see a sharp correction turn into a cascading feedback loop.

All you need is the wrong combination of events, in which buyers step aside or run out of cash, for a “market structure event” to occur — a crash scenario that isn’t based on fear, but instead relates to a group of traders or investors who all start doing something, or all stop doing something, at the same time.

To make an avalanche analogy, this would be akin to the loud noise that dislodges an unstable configuration of snowpack on a mountain side. Imagine, say, the Dow declining 500 to 1,000 points on the basis of election jitters, or the Nasdaq dropping enough to take a critical mass of Robinhooders out of the game, and then a cascading feedback loop taking over in the manner of 1987. (Then, too, we don’t have portfolio insurance these days, but we do have high-frequency algorithms that aggressively piggyback short-term market trends, amplifying their magnitude in doing so.)

Again, such a scenario is not the base case. But nor is it far-fetched.

This is why a combination of inexperience, greed, and a significant amount of leverage (in this case via call options) is frightening to observe. Experienced traders and investors know that combinations like that can end badly — and it doesn’t even require extreme negative emotion (like fear or panic) for that to happen.

Again, this doesn’t make a major decline the base case. It is just a scenario we are aware of, and wary of, because of how extreme the market structure distortions of 2020 have become.

In the TradeSmith Decoder we still have a portfolio with a dozen or so long positions, including a core holding in Amazon (AMZN) that is up more than 40% as of this writing.

If the base case holds, and markets climb higher on a long-term outlook of inflationary pressure and currency debasement, we expect these positions to do quite well.

But at the same time, we are cognizant of the extra risks embedded in this crazy market, because of the extraordinary wildness of 2020 and the unhinged nature of what the Robinhood crowd is doing.

And that is why, if the high-alert danger scenario starts to unfold — with, say, another round of market declines on election uncertainty morphing into something bigger — we will honor our risk points and go to cash as necessary, rather than assuming that things won’t get bad.

Because under the wrong circumstances, the market structure as currently configured could collapse, particularly in terms of highly concentrated Robinhood names. We are solidly long and will continue to be long — with rapidly growing enthusiasm for precious metals and precious metals stocks — but want to stay cognizant of that.

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