Prepare For Market Storms

08/16/2019 6:00 am EST

Focus: STOCKS

Landon Whaley

Editor, Gravitational Edge

Too many traders appeared unprepared by the recent, relatively mild equity market correction warns Landon Whaley.

The U.S. equity market decline in the prior week reminded me of my favorite passage from Benoit Mandelbrot’s book “Misbehavior of Markets.”

Mandelbrot tells us, “We have been mis-measuring risk. Greater knowledge of a danger permits greater safety. For centuries, shipbuilders have put care into the design of their hulls and sails. They know that, in most cases, the sea is moderate. But they also know that typhoons arise, and hurricanes happen. They design not just for the 95% of sailing days when the weather is clement, but also for the other 5% when storms blow, and their skill is tested. The financiers and investors of the world are, at the moment, like mariners who heed no weather warnings.”

This book (one of the best I’ve ever read related to markets) was published 15 years ago, and yet this passage nails the sentiment of the current investment climate.

I’ve seen all manner of excuses why portfolios got body-bagged during the 3.1% sell-off a week ago. Investors are blaming President Trump’s tweets and China, but the truth is, the S&P’s 3.1% loss was a run of the mill storm, not a hurricane. Unfortunately, most investors have built portfolios for the 95% of market days that are clement and not the 5% when storms blow, god forbid if an actual hurricane hit.

Since 1990, there have been 94 “storms” weeks when the S&P has experienced a loss of 3.1%, or greater. Given there have been 1,545 weeks over the last 29 years, investors should expect that 6% of the time, the market is capable of exhibiting that magnitude of downside risk over any stretch of five trading days.

As is usually the case, a Fundamental Gravity understanding can help us pinpoint when these stormy weeks are likely to arise.

During Spring Fundamental Gravities, 17 (18%) of the 94 storm weeks have occurred with an average loss of -4.7%. There have also been 17 (18%) storm weeks during Summer FG environments with an average loss of -4.8%. U.S. equities have experienced 18 (19%) storms during Fall, with an average weekly decline of -4.4%. And finally, during Winter, the S&P 500 has seen 42 (45%) storms with an average weekly loss of 5.3%.

For those of you who’ve been with us for some time now, it should come as no surprise that the majority of storm weeks have occurred when the U.S. is in a Winter Fundamental Gravity (as it is now). In fact, storms (some reaching hurricane status) happen roughly once every three months during Winter.

Everyone has heard the adage, “Red sky at night, sailor’s delight. Red sky in morning, sailor take warning.” Folks, if U.S. growth and inflation are falling together, the likelihood of another weekly 3% drawdown remains elevated, which means every trading day begins with a red sky until further notice.

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