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How To Manage A Stock Market Crash

S&P Downtrend Line Graph

Double Click on Any Graph for a Full Size View

We have seen unprecedented volatility in the stock and bond markets over the past several weeks.  The stock market has fallen faster and more violently than at any time since 1987.   Given that, I thought it would be instructive to take a visual look at the markets, so here are some graphs to help illustrate what has been happening.   The graph above shows the dramatic crash in prices – I’ve drawn in a downtrend line that needs to be broken so that we can get on the road to recovery with a Relief Rally.

After that, we will discuss the three major issues happening that are impacting the markets:  (1) European Financial System Liquidity that has led to an unreasonably strong US Dollar, (2) the Corona Virus and (3) the Oil War between Saudi Arabia and Russia.

 

S&P 500 Index

Let’s start with a review of a graph we last saw in a blog post from November.

S&P Forecast Graph Original

In a post from earlier in the year, I debuted an initial version of the above graph, and explained the primary pattern the market was taking (hat tip to Sven Henrich who used a very similar chart to identify the pattern).   This chart pattern is called a Megaphone and defines the outer boundaries of the potential stock market action.  You can either have a move up that breaks above the upper boundary at 3100 on the index or a move down that breaks the lower boundary at 2200 on the index.

In an August post, I added the two possible paths that the market could take:  (1) an orange dotted line that I called the Path to 3300, and (2) a pink dotted line that I called the Path to 2100.

In a November post I included the graph above that shows that we did break above upper boundary at 3100. I mentioned that the target I had was a measured target of 3300.  I also said that if we can break above 3300 and sustain that with a 3% move higher to 3400 we could see a major move higher into 2021 (3% is important as it is my investing Rule of 3 for breaking support and resistance).  As of November, we were well on our way to 3300.

On the graph below, we have an updated version of this chart with further annotations that shows:

  1. The market topped out at 3393 early this year, but not breaking above the 3400 resistance level established by the Rule of 3.  It has since crashed to the 2250 level, just above the bottom of the Megaphone and 2200 lower boundary and 2100 measured target.
  2. You will see that I’ve annotated in peach color an area of the chart between 2150 and 2350 that I call the Cyclical Bear Market Target Zone. I estimate that there is a 75% chance the correction/crash will bottom out somewhere in this zone and begin a move higher to the green color area Relief Rally Target Zone between 2850 and 3050 on the index.
  3. Once we get the relief rally, we should see a trading range develop between the two zones, but with an ultimate retest of the low before the market finally takes off to new All Time Highs in 2022.  I’ve drawn in some black and red arrows showing a hypothetical path the market could take.
  4. The stock market has a mind of its own, so I never like to say that it MUST do one thing or another. But I’m firmly in the camp of this being a cyclical bear market, rather than a secular bear market. Historically, cyclical bear markets within secular bull markets tend to be devastating, but very short-term in duration. Most last 3-6 months and average falling in the 20%-30% range. Q4 2018 was a perfect example of a cyclical bear market. Two of the three catalysts for this crash are more cyclical in nature (Corona Virus and Oil War) so I am giving the cyclical bear the 75% chance of being where we land.

S&P Forecast Graph 5yr

But what if the third of the three catalysts (European Financial System Liquidity) cannot be contained by the Fed’s Repo action?  Then we have a chance for a Secular Bear Market which takes much longer to resolve.  I am giving it a 25% chance of happening if this turns out to be a secular bear market.

But what if I am wrong and all three are more secular in nature and cannot be resolved in coming months?  Then we have the chance of either a Generational Bear Market (like the malaise between 1967 and 1981 where it took 14 years for the market to make a new high), or even worse a Centennial Bear Market (like 1929 to 1956 where the market took 27 years to make a new high).  You will find those in the next graph in gray colored areas.

The graph below is tough to read because it is so stretched out (you will most likely want to double click on it for a readable version), but it covers the past 12 years back to the 2008 Subprime Loan Crash.  The two zones to watch for are the Generational Bear Market Zone between 1250 and 1050 on the index and the Centennial Bear Market between 666 and 869 on the index.  It was important to stretch the graph back in time so we could determine the origin of the historic areas of support and resistance that form these two gray zones.

S&P Forecast Graph

I have rated both of these as unlikely because:  (1) I believe that the Corona Virus will run its course given that so many pharma companies are working on a cure and vaccine, one or more will be brought to market in an expedited time frame to beat this disease, and (2) Russia’s economy cannot sustain oil prices at $20 per barrel so they will be forced to play nice with Saudi Arabia and the Oil War will end.

Unfortunately, I do not believe the European Financial System Liquidity problem can be fixed in the short-term.  Their use of Keynesian Economics to justify:  (1) forcing the European Banks to buy the sovereign debt of the lesser financially solvent European nations with the artificial designation of Zero Risk Weight in their capital calculations – there is no market to liquidate that debt when liquidity problems arise because buyers will not touch it, and (2) negative interest rates that have wreaked havoc on European Banks’ net interest margins has led to a huge liquidity crisis because investors moved much of their investment capital into US Treasuries, thereby sending our own rates to historic lows in this flight to safety, instead of depositing cash into the banks.

Our Federal Reserve stepped in to fill the void left by the big US Banks when they shut off the European Banks’ access to overnight lending in the Repo market.  Our banks determined that the European Banks represented an unreasonable risk of default and ended their overnight loan program even though it was secured under the Repo contract.  Unfortunately, this issue has turned from a short-term fix as described by the Fed in October 2019 to an intermediate to potentially permanent problem as the issues in Europe have worsened.  Certain of the European countries have ended negative rates on their debts but it does not look like the market has responded to that action and there is a general feeling that the European Central Bank has lost control of the European economies.

Ultimately, the cash moving out of Europe will move into US stocks and drive our market back to new highs, much like happened in the fourth quarter of 2019 and January 2020.

 

US Treasuries

The problems in Europe have significantly impacted our treasury market, driving yields down to record low levels.  Here is a graph of the 10 year US Treasury Note Yield for the past two years:

Treasury Yield Graph

You can see that 10-year Treasury yields were fairly flat until August 2018.  Then money started to move out of Europe into treasuries, driving the yield down from 3.2% to the 1.5% area where they plateaued until January 2020.  The Fed’s Repo action stabilized things and provided the liquidity the European Banks needed for that four-month plateau, then it proved to be inadequate.   Money again began to flow out of Europe driving the yield down to 0.34%.

We have since rebounded to the 1.1% area based upon the Fed’s multi-trillion dollar intervention in both the Repo market and the Commercial Paper market (which had also started to freeze up), as well as their interest rate cuts returning to their ZIRP levels of pre-2018.

 

Our Strategy

Stock Market Strategy

I have written on the blog in previous posts that as the market moved higher in 2019, we got increasingly more conservative with our clients’ investment portfolios.   Valuations continued to expand, driving the market higher, while corporate earnings fell compared to 2018.  That is not a sustainable market situation and prudent investment management dictated that we raise cash and buy bonds.

When the crash began in February, we started investing those funds in both index ETF’s and individual company stocks.  We have been buying all the way down and still have some liquid cash that we continue to add to the market at these low levels.  Our plan is to be fully invested prior to the Relief Rally starting.

Based upon the most likely scenario for the market discussed above, we anticipate a bounce higher to the Relief Rally Zone (2850 to 3050 on the index) before a retest of the lows.  As we near that Relief Rally Zone, we will again get more conservative by raising cash ahead of the potential retest of the lows.  If the retest does not happen and the V shaped recovery moves the market above the zone, we will reinvest the cash we raised in anticipation of a move back to the 3300 level on the index.

Bond Market Strategy

In the time frame between September 2019 and January 2020, as the drop in treasury yields began to plateau, we reduced bond portfolio duration by selling our longer duration bond funds and adding to short-term and floating rate bond funds.

When we moved below 0.5% on the US Treasury, we liquidated all the longer duration bond funds in favor of short-term treasury bond funds.  The exception to this is the allocation to two actively managed fixed income mutual funds that have a good history of managing interest rate risk and holding onto any other short-term bond funds in client accounts.  We also maintained exposure to a few longer duration holdings in accounts where we have income beneficiaries that live off the income distributions from their trusts.  Finally, we did not change anyone’s ladder of individual bonds, other than to reinvest maturities as appropriate.

 

Summary

As the stock market tries to find a bottom in our cyclical bear market zone and the bond market tries to find appropriate yield levels across the yield curve, we believe we have positioned client portfolios to take advantage of what we see coming in the most likely scenario.  If that does not happen, we will adjust portfolios according to what is happening in the market.  As I have written multiple times in the past in blog posts, invest what you see, not what you believe.

We don’t invest our politics or our fears of the unknown.  We work to quantify the known data and the observable chart patterns so that our clients profit to the greatest extent possible.  No one is ever right 100% of the time in the investment business, but we strive to be right more often than our competition and consistently accomplish that.

Check back on this blog as we will be posting updates to our strategy as the situation develops.

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For those of you who like scary movies, the second video below comes from the book adaptation of Stephen King’s The Stand.  For those of you who do not like scary movies, here is a concert video from 1977 of the same song.

—Mark