The stock market has had a violent two-day selloff, resulting in the S&P 500 down 8.24% from the all-time high reached last week. In this Special Report, we look at the reasons behind the selloff, what we have done in client portfolios, and what to expect next.
What Happened?
The Dow Jones Industrial Average was down 1,175 points today (the largest point decline in history), following a 665-point selloff on Friday.
So what drove this selloff?
First of all, stock markets are very complex systems, and there is usually no one “thing” that moves markets up or down. We have been watching various technical indicators that showed a stretched market that was vulnerable to a pullback. This is exactly what we are seeing now.
What is most surprising is how violent this move has been. We think these are the following reasons for the selloff:
- Overextended Market Conditions. Various measures we watch to understand the underlying health of the market were showing signs of a well-overdue pause in the strong uptrend from last year. We discuss these items in the next section below.
- Increased Computer Trading. There are many algorithms that participate in buying and selling of stocks, and this has led to an increase in the velocity of sell orders in the past decade. Once selling begins, it can snowball into increased selling across various markets.
- Political Risk. A new Fed chair was officially sworn in, and given the impact the Federal Reserve has had on asset prices in recent years, there could easily be profit taking on this news. Political uncertainties continue around various FBI investigations, and the tax cut has now become old news.
- Decreased Liquidity. Almost every selloff in markets is driven by changes in liquidity. What has been a fairly liquid market over the past year shows us that when liquidity is reduced, markets fall.
The chart above shows the Dow Jones Industrial Average since last summer. The massive selloff of the past week is reflected on the right of the chart. What was a calm, consistent move higher has changed rather dramatically.
There is an old saying the markets “Go up the stairs and down the elevator”. That certainly is the case right now.
It’s All About the Flow
Bottom line, market prices are ultimately about the amount of buyers and sellers in the market. We refer to this as asset flow. There are very large investing groups in the markets whose strategies can move asset prices. One of these large investor types are called Risk Parity funds.
Goldman Sachs released a report today that discussed the potential for continued selling pressure over the next week due to these types of systematic trading funds. If their conclusion is correct, then small cap stocks and emerging market stocks may see the brunt of the selling pressure near term.
The past week has had a market with many more sellers than buyers. Fortunately, there has not been a dramatic increase in volume, suggesting that we are seeing a lack of buyers causing the markets to decline, not necessarily an increase in the amount of sellers. That doesn’t make the decline less painful, but is does suggest the selling pressure is not as bad as what the market declines show.
What Did We Do Today?
We adhere to a disciplined risk management process, designed to help our clients withstand these kinds of shocks through the use of our different investment strategies. Although the markets have seen major selling, our investment process has prepared us for how to handle this kind of move. Our process includes:
- Aligning our clients’ investment portfolios with their individual goals. Do not take unnecessary risks.
- Unlike most wealth managers, we are not afraid to move to cash to wait things out. We do this in an unemotional and disciplined way, only when our signals tell us to (see more about this in the paragraph below).
- We have exit strategies in place on every position, so that we know when to get out and move on to something else.
- We have been shifting our bond focus to funds that take better advantage of rising interest rates, and these funds have been mostly immune to the recent pullback.
- We have re-entry signals in client portfolios, so that funds moved to the sidelines have a strategy to get back invested. This also includes clients with cash on the sidelines looking to invest.
Ok that’s nice, but what did we actually DO?
Today, we had sell signals occur in our proprietary trend model, and exited our S&P 500 index position for the first time since last August. The proceeds were moved to cash. We also had other sell signals trigger on various individual stock positions. On the whole, our clients had anywhere between 10% to 18% of their portfolio move from stocks to cash this morning, before much of the fireworks began this afternoon.
The last time our trend model had a sell signal was in August. This portion of client portfolios were in cash for 10 days before getting a re-entry signal. In our work doing back-testing of our strategies, this sell signal had times where it was in cash for months before having a new buy signal. Bottom line, we are going to listen to our signals and act accordingly.
Previous Steps Taken for Clients
It is not simply what we did today that is important. Over the past two months, our investment signals have consistently moved our clients stock exposure into large-cap US stocks, and out of the more aggressive areas of the market such as Small Caps and International stocks. The market has been giving signals to maintain exposure to stocks, but in the more conservative areas of the markets. We listened to these signals, acted upon them, and as a result our clients had very little to no exposure to international stocks and small caps, where the brunt of the selloff has happened.
Overall, we continue to monitor portfolios very closely many times throughout the day and have been taking steps to prepare for draw-downs such as today. We have exit and re-entry strategies in place, and we will execute our strategies with discipline.
Is the selloff over?
Honestly, we don’t know, but what we do know is we are prepared and ready for whatever the markets throw at us next. We list a few of the potential outcomes below.
What to Expect Next?
Every market selloff is slightly different. But we believe strongly that analyzing past markets will help give context as to what may be in store next.
We have written about this multiple times over the past few months. See our previous reports:
What our analysis of previous market cycles reveal is that markets tend to undergo a longer-term process when forming major market tops. Maybe this time is different, but it usually isn’t.
What we expect is to see:
- Continued volatility in the very near term as markets find their footing.
- Given the violent nature of this pullback, we would not be surprised to see snap-back rallies that are also equally strong.
- Increased uncertainty as investors nerves become more frayed.
We hope this is not the start of a larger bear market, and our analysis of previous cycles suggest it is not. But hope is not an investment strategy. We have put in the work so our clients can have peace of mind that we are taking every prudent step to address a variety potential market outcomes, good and bad.
Please let us know what questions you have. We welcome the dialogue and look forward to acting in your best interest.
Disclaimer This presentation is for informational purposes only. All opinions and estimates constitute our judgment as of the date of this communication and are subject to change without notice. > Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.
