Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.
— Charles Mackay, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds
Yesterday, the S&P 500 suffered its worst day in approximately 4 months, shedding -1.33%. What you think of that says a lot.
Briefly consider some market history:
- Since 1962, a typical year for the S&P 500 averages 21 days losing -1.33% or greater.
Chalk up 1 for 2014. Mid-way through Month 1 of 12, that roughly on-pace and signifies nothing remarkable. But that 4 months (by the way, the last occurrence was 08/27/13 at -1.59%) seems like quite a long time is exactly that.
- How many days did the S&P 500 lose -1.33% or more in 2012? Answer: 13.
- How many days did the S&P 500 lose -1.33% or more in 2013? Answer: 9.
A little math tells you 2012 and 2013 together just make the historic average for any single year.
Perhaps that’s an anomaly? What about -2% or more?
- How many days did the S&P 500 lose -2% or more in 2012? Answer: 3.
- How many days did the S&P 500 lose -2% or more in 2013? Answer: 2.
The average year since 1962? 9.
What about -1% or more?
- How many days did the S&P 500 lose -1% or more in 2012? Answer: 21.
- How many days did the S&P 500 lose -1% or more in 2012? Answer: 17.
The average year since 1962? 34.
If you’ve waded through those statistics, one thing is readily apparent: 2012 and (especially) 2013 posted a gross deficit of “big” down days compared to the historical average.
These numbers put a fine point on and are a rote function of something any active observer of stocks has undoubtedly sense over the past couple years: stocks have moved broadly higher and realized volatility has made a sustained move lower. A rising trend, improving headline economic figures, a world awash in cheap liquidity and some ebullient sentiment will do that.
Something else has occurred over this period, though, for which these numbers are a major clue. That the 504 trading days of 2012 and 2013 added trillions to our collective PnL is a simple matter of record. Next to such fantastic annual returns, though, the vastly important question of how they came about (and what that means) is easily overlooked.
Day after day, week after week and month after month, 2013 was a market of unremitting strength. Moreover, it was a market that declined just enough to feign weakness before overwhelmingly reasserting itself, time-and-again.
But something strange happened on the way to SPX 1850: the further stocks climbed, the more static and featureless their advance became. To anyone looking with consistency, the hundreds upon hundreds of hours of monochromatic market behavior provided a functionally identical stimulus over and over, evoked no more succinctly, absurdly and accurately than through the BTFD and BTFATH memes that have become pervasive throughout social finance. In the end, SPX finished 2013 up almost 30%, and the market at large received 252 days of inculcation that transmogrified “buy the dip” into a behavioral predilection for buying any dip with a subtly mounting sense of impunity and hubris. The return that resulted is because most of your peers (maybe including you) in the market game couldn’t stop bidding stocks higher; but that it happened with all the placidity and tractibility of a VIX constantly probing below 13 (and often 12) is most remarkable of all.
Now last year’s gains are neatly tucked away on the books and in tax docs and the YTD return column reset to 0%; but their legacy of a massive black hole of cognitive myopia hasn’t gone anywhere. It is, after all, axiomatic that any market from which neophytes exact historically superior returns as an unwitting function of crude stimulus-response is “pricing in” massive inefficiency.
But why not just say “the market is complacent” and be done with it? Because attributing complacency to the entire market without asking how and why is all-but worthless. Also, speaking objectively of the market in this way is self-refuting because we are the market; and however skeptical one may be, the low volatility regime of the last year or two has created dispositional affects for bulls and bears alike.
One feature of our cognitive life uniting all of us, despite how we may differ in sentiment, is the recency effect. At its most basic, this memory phenomenon refers to our tendency to best recall those items on a list (more broadly, events) that occur last. Negativity bias does cause those with a living memory of it to vividly recall the market events of 2000 and 2008, apparent in the constant references to these outlier events as rejoinder to 2013’s outstanding upside performance. However, the weight of those events for collective market sentiment continues to slowly wane as 1) time passes, 2) post-2009 entrants to financial markets who view 2008 with emotional dispassion proliferate; and 3) the steady state of higher returns amid 4) continually sloughed-off macro headwinds seemingly offsets and overrules those years. The events of 2000s will continue to leave a long shadow, but our composite memory of markets has changed
Paired with the unmitigated positive stimuli of 2012 and 2013 that saw bulls incessantly rewarded and bears mercilessly punished; and the fleeting superficial significance of events occurring some 1300 market sessions ago, despite any intellectual objections, the steadfast market behavior of the last year has impacted everyone. What’s been impacted? Any investing or trading methodology with room for discretion, for one thing. Trading theses – even risk-off theses – are sensitized to the long side. Even discounting perma punditry and impish trolls, propositions and beliefs about motive legs higher have a sense of prosaic – even bored – and routinized assurance about them. Calls for pullbacks are, in contrast, measured, half-whispered and wholly without bravado. And why wouldn’t they be? Look at those statistics.
But those statistics will change; and that change will begin from this place to which the recent past has acclimated us. If the last 42 years are a representative sample, the shift will be toward more down days with greater negative performance. When those occur in proximity to one another, legitimate corrections (still defined as >-10%)Â result.
That is the point the cognitive practice to which many of us have been acculturated encounters a market environment it will not and cannot believe. To deprogram, our inculcation will demand something like the grieving process as we shift from disbelief to anger to bargaining to depression to final acceptance.
This may seem unduly market-pessimistic, but a deep bear market isn’t an inevitable outcome. One of the most interesting features in 2013 was an inability to steer the market conversation away from the narrative dichotomy of “The Top/Not The Top” every time VIX moved above 15 and/or the S&P shed more than -2%. Bears cheered; Bulls balked; but anyone beyond the stereotypical definitions of this trope observed these light market tremors with apprehension precisely because even modest implied volatility doesn’t correspond with the lessons of the market’s last 2 years.  Market observers are now more sensitized to upticks in volatility and even nominal deviations from all-time highs because the recency effect treats these events as outliers – this is reflected qualitatively in their sentiment about talk of tops; and quantitatively, among other metrics, in their lavish deployment of margin debt and tendency to aggressively mark up out-of-the-money SPX puts at the first sign of trouble. Ironically, in 2013 this hypersensitivity contributed the effect of creating ever-more-shallow pullbacks; a phenomenon with a limited shelf-life that already has a why to end; and now just needs a when.
Any student of the market will intellectually affirm volatility is usually higher and returns are usually lower; but after adapting to another environment over a concatenation of hundreds of sessions, their new-found intuition is likely provide a compelling feeling that says otherwise. Once a sell-off does occur, this conditioned response-that-has-become-an-unconditioned response begins to up-end and unravel because the shift into the volatility paradigm of a cluster of major negative days violently pulls it apart; but most market participants (or, as a mathematical certainty, most working capital) are not prepared.  This intuitive drag, not to mention the lag of adequate statistical evidence to the contrary (e.g. that 2014 statistic of “1 sessions -1.33% or greater” may yet see 5 or 50 more like it) are among the primary reasons tops are a process and negative market momentum is very difficult to arrest once it firmly takes hold.
Twitter: @andrewunknown and @seeitmarket
Author holds no exposure to instruments mentioned at the time of publication. Commentary provided is for educational purposes only and in no way constitutes trading or investment advice.
Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.
