Market Commentary: Wild Week on Wall Street Ends with Rally

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In our Tuesday bulletin, we noted, "Peak to trough (earlier today) the S&P 500 declined 9.7%, not quite a correction (defined as a decline of 10%.) However, we expect the market WILL have a few more bobbles this week or next, making the correction "official." As we always say, 'When the stock market has a heart attack, it doesn't go back to the gym the next day.'"

Indeed, the market swung wildly through the next several days, falling as much as 11% from the January 26th high. On Friday, the Dow fell 450 points in the morning, rallied into the close with a gain on the day of 330 points. The S&P 500 closed with gains but is down 8.8% from its record high and is now down 1.8% on the year.

What does this mean for our clients?

Bottom line we've been expecting this for a while. For families who became clients in September 2017 or later, we invested half of their equity exposure when they came on board, told them we'd invest the rest either 6 months later or after the market sold off 6%. The obvious question, if we thought stocks were overdue for a correction in September 2017, why didn't we sell stocks then? The answer: until OTHER investors agree stocks are overvalued, they'll just continue to rise. From September 1st through January 26th, the S&P 500 gained another 16%.

Why did the market trend break on February 2nd and not a month earlier or a month later? The human brain craves certainty, wants a logical explanation for everything. But the stock market is not as "logical" as we would like to believe.

In the past, we've asked our clients to imagine that the stock market is a giant engine block suspended in the air by thousands of piano wires. There's a mischievous elf snipping wires a couple at a time. For the most part, the loss of any one wire does not affect the suspension of the engine block all that much. But once in a while, the loss of one wire exceeds a tipping point. The block lurches violently, in the process snapping scores of wires, which create other tipping points. After a few minutes of violent swinging and rotation, the engine block settles into a new equilibrium, and the elf starts snipping again.

Last week, the wire in question was a positive jobs report including an uptick in real wages, which triggered fears of an uptick in inflation and rising interest rates, which pushed down the fair value of the US stocks. That news should have knocked no more than 200 points off the DOW, which actually fell 563 points on Friday 2/2, and plummeted another 1600 points on Monday 2/5 before closing down 1175. Over 6 days, the DOW declined 1996 points.  What explains the difference?

The market is just not ONE entity, but instead is made up of multiple participants with different agendas including:

  • Big mutual fund complexes - Fidelity, Vanguard, TRowe Price

  • Exchanged Traded Funds (ETF's), primarily index ETF's

  • High Frequency Traders - machine driven trading algorithms typically 50-60% of daily trading volume but probably 80% last week

  • Individual retail investors (a vanishing percentage)

The HFT trading is entirely tick but tick, completely indifferent to underlying values. Most days, these traders simply "scalp" fractions of pennies from the trades of the mutual funds and exchanged traded funds. Once in a great while high frequency trading creates a "flash crash," where selling begets more selling begets more selling. Retail investors, the weakest hands in the market, tend to panic sell. We believe that was a factor last week.

We also believe the routs in other markets contributed to retail investor unease. In our year-end review, we wrote, "If Bitcoin plays out like most manias, we're just past the "bull trap" stage and about to enter the "fear" stage. Our opinion: if you own Bitcoins right now, sell enough to take out your original investment. If the rest of your position goes to zero, at least you retrieved your original capital. If you bought in the last month, sell ALL, accept your losses and move on."

At that point, Bitcoin had already fallen from a mid-December high of $19,900 to a year end close of $13,769, to as low as $6,000 last week (currently $8,300.) We expect Bitcoin to level off between $1,000-2,000 in the next three months. Meanwhile, there are hundreds of thousands of hapless investors who mortgaged their houses or maxed out credit cards to buy Bitcoin last fall. The Bitcoin exchange mechanisms are breaking from volume, so many are locked out from selling. When you can't sell what you want, you have to sell what you can, such as US stocks and funds.

What next?

We were encouraged that stocks closed up on Friday. That up rally was not new money flowing into stocks, but rather "short covering into the weekend." Traders don't like to carry open long or short positions over weekends because too much may change before trading resumes. So typically, we'll see counter trading (selling after a rally, or buying after a selloff) into weekends, and also around month ends and quarter ends. Still, that up rally gives other investors a chance to regain their composure.

We simply suspended buying OR selling last week, including routine re-balancing. We'll just wait until the market stabilizes around current levels and then resume trading. For those large cash positions for new clients that we described above, we'll probably invest another portion soon.


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Do you have more questions?
Feel free to contact me.

David Edwards, President
DavidEdwards@HeronWealth.com
Direct: (347) 580-5281