Several months ago, I penned an article about the problems with “passive indexing” and specifically the problem of the “algorithms” that are driving roughly 80% of the trading in the markets. To wit:
“When the ‘robot trading algorithms’ begin to reverse (selling rallies rather than buying dips), it will not be a slow and methodical process, but rather a stampede with little regard to price, valuation, or fundamental measures as the exit will become very narrow.”
Fortunately, up to this point, there has not been a triggering of margin debt, as of yet, which remains the “gasoline”to fuel a rapid market decline. As we have discussed previously, margin debt (i.e. leverage) is a double-edged sword. It fuels the bull market higher as investors “leverage up” to buy more equities, but it also burns “white hot”on the way down as investors are forced to liquidate to cover margin calls. Despite the two sell-offs this year, leverage has only marginally been reduced.
If you overlay that the S&P 500 index you can see more clearly the magnitude of the reversions caused by a “leverage unwind.”
The reason I bring this up is that, so far, the market has not declined enough to “trigger” margin calls.
At least not yet.
But exactly where is that level?
There is no set rule, but there is a point at which the broker-dealers become worried about being able to collect on the “margin lines” they have extended. My best guess is that point lies somewhere around a 20% decline from the peak. The correction from intraday peak to trough in 2015-2016 was nearly 20%, but on a closing basis, the draft was about 13.5%. The corrections earlier this year, and currently, have both run close to 10% on a closing basis.
My best guess is that if the market breaks the October lows, which given the current state of the market is a very high probability, we will likely see an accelerated “sell off” as the realization a “bear market” starts to set in. If the such a decline triggers a 20% fall from the peak, which is around 2340 currently, broker-dealers are likely going to start tightening up margin requirements and requiring coverage of outstanding margin lines.
This is just a guess…it could be at any point at which “credit-risk” becomes a concern. The important point is that “when” it occurs, it will start a “liquidation cycle” as “margin calls” trigger more selling which leads to more margin calls. This cycle will continue until the liquidation process is complete.
The last time we saw such an event was here:
Notice that from January 1st through September of 2008 the market had already declined from the peak by 14.5%. This “slow-bleed” decline was dismissed by the bullish media as we were in a “Goldilocks economy:”
There was no sign of recession
Rates were rising due to a strong economy.
Earnings expectations were high and expected to continue to expand bringing “Forward P/E ratios” down to historical norms.
Economic growth was robust and expected to accelerate in the next year.
Global growth was expected to pick back up.
Then, the “Lehman moment” occurred and the world changed and the realization we were in a recession would occur 3-months later.
From the end of September to March of 2009, the market lost an additional 46.1%. The bulk of the at loss occurred quickly as banks and brokerage firms scrambled to pull in margin lines.
The selling was relentless. It was also where many individuals found out there is a point where portfolios become an “Imported Rug Store” and “Everything Must Go.”
This is the problem with “margin debt.”
This is why we continue to urge caution.
The “bear market” in stocks is growling more loudly.
Last week, we further reduced equity risk further bringing exposures down to just 43% of our portfolios. On a rally to the 200-dma which fails, we will reduce risk more.
This week we are going to review our primary buy/sell indicator charts for the S&P 500. As shown below, the daily chart is much more noisy in terms of signals and is meant for more short-term trading activity. However, what is important is the signals are fairly good (pink shaded bars) at catching downturns in the market and suggesting a reduction in overall risk exposure. That is the case once again over the last month.
We can slow the signals down reducing the signal to just breaks of the long-term moving average. Once again we see a fairly consistent ability to navigate the more important downturns in the market. Importantly, the sell-off in January did NOT violate the long-term moving average and therefore did not register a sell-signal. However, the current sell-off just triggered that signal to reduce equity risk this past week.
Action: After reducing exposure in portfolios previously, we reduced risk further this past week. Sell weak positions into any market strength on Monday.
Since we prefer longer-term holding periods for our positions, we prefer to use weekly and monthly price periods as it reduces the number of signals significantly. This allows us to capture the trends of the market while still managing to protect capital from more significant declines.
(Note: this does not mean we will miss ALL the declines. It simply means we will avoid the risk of a more substantial decline should one occur. We are NOT “market timers” but rather “risk managers.”)
As shown below, on a weekly basis, a “sell signal” has been registered for the second time this year suggesting that investors reduce equity risk in portfolios.
Again, we can reduce the number of signals further by using a confirmed cross of a long-term moving average. This process keeps portfolios primarily allocated toward equity risk over long periods of time. When “sell signals” occur, they tend to be important to pay attention to.
This past week a “sell signal” was issued.
I want to caution you that by the time longer-term sell signals are issued, the market tends to be more extremely oversold and due for a reflexive bounce. In 2015, we saw a significant bounce that was worth selling into before the next decline in 2016. It was the intervention of the global Central Banks in 2016 that kept a “bear market” from most likely ensuing.
Today, Central Banks are extracting liquidity and show no intent in coming to markets rescue. It is likely wise to use any bounce over the next few weeks to reduce risk and raise cash.
Action: Sell weak positions into any strength next week.
Moving back to a monthly view, signals become much slower and much more important. However, signals are ONLY VALID on the 1st trading day of each month. Therefore, while the markets have registered a monthly signal as of this week, it will ONLY be valid if the markets fail to rally enough to reverse it by the end of the month.
Nonetheless, the deterioration in the markets is extremely concerning and by slowing the signals down further to crosses of very long-term moving average, the risk to investors becomes much clearer.
Action: Reduce risk on rallies, as detailed above, and look to add hedges.
As always, the messages being sent by the market are more than just concerning and DO suggest, as we have stated on the last couple of weeks, that the bull market has indeed ended for now.
It is make or break for the markets over the next couple of weeks. If the markets fail to rally, more important long-term “sell signals” will be triggered which will likely suggest further declines in the markets are in the offing.
Of course, with a Fed bent on continuing to lift interest rates, earnings showing real signs of deterioration, ongoing trade wars and tariffs, continued reductions in Central Bank liquidity, and corporations curtailing share buybacks – the market appears to be finally starting to “run on empty.”
Next week, we will look to raise more cash and add hedges on any failed rally attempt at the 200-dma for now.