Posted | by David Moenning |
The Crash Playbook image

By now, everyone knows that after a prolonged period of calm, volatility has returned to the stock market - in a big way. Just about everybody in the game, including yours truly, predicted this would happen. There was little doubt that the period of extremely low volatility would, at some point, come to an end. And it is ironic that it was all the bets placed on the market remaining calm that wound up creating the renewed volatility. Volatility that led to a negative feedback loop in the derivatives markets, which caused the algorithms to run at max speed this week.

Some folks are calling the action seen this week a "crash." Frankly, I'm not sure a decline of 9.7% on an intraday basis for the S&P 500 qualifies as a crash. And to be fair, the S&P has fallen just 7.8% from top to bottom so far and after yesterday's furious rebound, the total correction now stands at 6.2%.

But, I get it. The action seen over the last three days certainly qualifies as at least some sort of mechanically driven flash crash type of event. And when you consider the possible fundamental inputs of higher than expected economic growth, inflation, and rates, I can see the bears' point here.

In addition, there is the argument that today's consumer tends to stop spending on a dime when the stock market goes into crisis mode. I'm not suggesting this will occur, mind you. No, I'm simply noting that if the freak-out in the stock market continues to make headlines, the economy, which is driven by the consumer, could suffer. It has happened before.

So, where do we go from here? I for one will be watching two things very closely. First, the action in the bond market. And second, the action in the stock market itself to see if traders will be following the "crash playbook."

The action in the bond market should be interesting and/or will be a good "tell" regarding economic and inflation expectations. Lest we forget, it was the spike in yields that triggered all the talk that the Fed is behind the curve and that rates will rise more than expected this year.

To be sure, we've seen rates back off over the past couple of days. Some of this move can surely be attributed to a "flight to quality" as traders tend to sell stocks and buy bonds whenever the stock market enters crisis mode.

But where rates go from here will likely tell us whether or not the "overheating" argument has legs. Thus, I'll be watching last week's high water mark of 2.854% on the 10-year. If rates break out again and continue to climb, the bearish fundamental story for the stock market may gain momentum. If not, then I'll opine that we may have seen the worst of the current bond rout.

As for the stock market, "crashes" tend to follow a pattern. I first learned of the "crash playbook" in 1987. And while history never repeats exactly, it does indeed tend to rhyme - especially when crises are in play on Wall Street.

Stage one of the decline is "the dive." Stocks flush lower in an emotional fashion in response to some new input. Then, since Wall Street tends to overdo everything in both directions, a furious rebound (aka the dead cat bounce) ensues. This move makes everyone feel better and tends to be short and sharp. From there, the original reason for the dance to downside resurfaces and stocks "retest" the lows. And if the retest is successful, THIS is when dip buyers tend to take action in a meaningful way.

The problem here is that with computers in control of the action when things get heated, it becomes hard to tell where we are in the playbook. So, the question is this. Are we currently seeing the rebound phase or are we still in the dive?

Given that at least some of this week's hysterics can be attributed to the "short vol" trade blowing up and all the associated forced selling, some, including UBS's Art Cashin, argue that the low of "the dive" was seen at yesterday's open.

As such, we "should" see stocks either continue to bounce (and bounce hard) - or - move into the "retest" phase.

On that note, remember that the market does NOT have to move back to the lows in order for the move to qualify as a retest. No, any movement "toward" the lows generally qualifies.

The bottom line is anybody looking to put cash into this market needs to (a) be on their toes and (b) keep an open mind - especially on the macro narrative.

Thought For The Day:

Expect the best, expect Divine guidance, expect your fortunes to change... expect a miracle. -Wayne Dyer

Wishing you green screens and all the best for a great day,

David D. Moenning
Founder, Chief Investment Officer
Heritage Capital Research
Serving Financial Advisors since 1989
Serving individual investors since 1980
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Disclosure: At the time of publication, Mr. Moenning held long positions in the following securities mentioned: None

Note that positions may change at any time.


Disclosures

The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.

Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided.

Mr. Moenning may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Positions may change at any time.

The analysis provided is based on both technical and fundamental research and is provided "as is" without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.

Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.