We’ve had the 20%+ rally, now here comes the hype. The explosive gains put in by the world’s equity markets over the last few days have been impressive, to be sure, and in some quarters may even have stirred a few animal spirits. Anecdotally it seems that for some, the fear of missing out on a V-shaped equity recovery is very real, and the media is at least beginning to contemplate the notion of a new bull market. But here’s the thing: the start of a bull market, much like the top on an economic cycle or the last passionate kiss of a relationship, is usually only observable in retrospect. Applying static definitions to dynamic systems will only make you lose your way.
- Whether it was rebalancing, an oversold bounce, or the formation of a legitimate bottom, the equity price action over the past few days has been impressive. Yet in some ways it’s been a little too impressive. The road map we discussed last week argued that the response phase of the crisis should engender a reduction in volatility, but it’s hard to call a trough-to-peak gain of nearly 20% within the span of a few days a “lower volatility regime,” and bitter experience has shown that that which can rally sharply can fall just as quickly.
- A threshold of a 20% decline is often used to define the onset of bear markets, and for most equity indexes the definition usually works fine. After all, the nature of volatility is generally such that it is relatively low when stock markets are at their peak, and as a result a 20% drop represents a “significant” move. It’s not particularly useful to apply the same definition to higher volatility instruments such as natural gas; when the one-year volatility is usually above 40%, a drop of 20% is just statistical noise.
- The same principle holds for calibrating rallies during periods of exceptional volatility. When the S&P 500 was at its peak, the one-month historical volatility was about 14%. This implies that a 20% decline over a month would represent a nearly five standard deviation event. (As it turns out, of course, the drop was even swifter, implying an even fatter-tailed outcome.) Now, however, the one-month vol is roughly 83%, meaning that a 20% move over the span of a month is only a 0.83 standard deviation phenomenon — not worth raising an eyebrow over, and certainly not worth using to draw conclusions about the intermediate future.
- This phenomenon was evident during the previous financial crisis. For example, the S&P 500 rallied 24% over three trading days in October 2008, rallied nearly 20% over a week or so in early November, and put in a 27% rally from Thanksgiving through the turn of the new year. Do you remember the great bull market of October 10-14, 2008? Me neither, and none of these fantastic rallies came close to marking the ultimate low.
- It may be a cliche, but while this is a great traders’ market, investors need to be a little circumspect in how they interpret the numbers flashing on their screens. Price movements have done a fair amount of work on the asset allocation rebalancing, and markets now have to contemplate what the weekend might hold; “I don’t like Mondays” has rarely been more resonant than over the past few weeks.