The recent downside flush in US equity markets reminded Landon Whaley of his favorite passage from Benoit Mandelbrot’s book Misbehavior of Markets.
The Brot drops this knowledge bomb on 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 was published 16 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 this latest, four-week, sell-off. But the truth is, a weekly loss of 2%, or more, is a run-of-the-mill hurricane. Unfortunately, the vast majority of investors have built portfolios for the 95% of market days that are clement and not the 5% when storms blow.
Since 1990, there have been 211 “hurricane” weeks when the S&P has experienced a loss of -2.0% or greater. Said differently, based on the last 30 years of stock market data, investors should expect that 13% 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 hurricane weeks are likely to arise.
During spring fundamental gravities, 18% of stock market hurricanes have occurred with an average loss of -4.7%. We’ve also experienced an additional 18% of all hurricanes during summer FG environments, with an average loss of -4.8%. US equities have experienced 19% of hurricanes during fall, with an average weekly decline of -4.4%. And finally, during winter, the S&P 500 has seen nearly half (45%) of all hurricanes 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 hurricane weeks occur when the US is in a winter fundamental gravity. This historical fact is critical today because, over the last three weeks, my US fundamental gravity model has gone from indicating a 15% probability of a winter FG during Q4 2020, to a current reading of 63%. Keep in mind: this is the same model that allowed me to make the mid-February call for a Q2 2020 recession, pre-COVID.
When I was a kid riding in the car with my old man, he’d say, “Red sky at night, sailor’s delight. Red sky in morning, sailor take warning.” Folks, as long as the probability of a winter fundamental gravity is greater than 60%; then the risk is rising rapidly for a stock market crash in Q4. From this point forward, every trading day begins with a red sky until further notice.
To learn more about Landon Whaley, please visit WhaleyGlobalResearch.com.
