What We Can Learn from Friday’s Big Stock Market Selloff

Stock Market Selloff

Seeing the stock market sell off a couple of percentage points on average is usually not something to be too concerned about. Some selloffs tell a bigger story than others though.

The numbers are in for the current week, and while we ended up right around where we started, with the way the week played out, especially with the amount of selling that went on Friday, there are signs that the market may be having more trouble getting past the economic decline that we’ve been wrestling with lately.

All year we’ve been hearing that the economy is slowing, but this did not really stop the stock market from moving ahead, as investors took all this in stride. We could say that the overall outlook was mostly optimistic, optimistic enough to move past these concerns, although that might be changing a bit.

There’s nothing really that new on this front that we didn’t have going on earlier in this move, even though the forecasts have come down a bit. They didn’t come down that much though, and a good argument could even be made that we needed some of this to buy us the Fed not planning on raising rates at all this year, down from an expectation of two hikes when the year started.

That’s a good trade actually, seeing that we really haven’t seen the numbers drop all that much, and perhaps just enough to have them arrive at this welcome decision. However, concerns about the economy have been mounting, and this has influenced the overall market sentiment and particularly its tolerance for it slowing down further.

Friday’s market decline is being blamed primarily on the fact that the 10-year yield on treasury bonds has dropped below the 3-month yield on treasury bills, and when this persists, it is strongly correlated with a recession.

The correlation is with 10 consecutive days of this, a type of yield curve inversion, although the 3 month and 10 year isn’t the only one to look at here. It’s the one that is so strongly correlated with the word recession, a word that can indeed strike fear into investors who are prone to want to get out during the bad times.

The Magnitude of Recessions is What Defines Them

We also need to realize that just because we get an inversion of this sort for 10 consecutive days, this does not in itself mean that a recession is underway, only that it is likely to happen over the course of the next 2 years. The relationship isn’t even a causal one, it is more like this happens at some point before a recession occurs, but this does not necessarily mean that when it happens, we will have a recession during the next 2 years, meaning negative growth for 2 consecutive quarters.

Seeing growth disappear for a couple of quarters isn’t in itself that alarming actually, as the decline may be pretty slight and the duration may actually be a couple of months, as opposed to bigger and longer recessions. We have to define recession somehow, and the threshold is a pretty minor one, but it’s the bigger ones that we need to worry about a lot more.

When this indicator indicates an inverted relationship, this means that people are either not buying 3-month T-bills, they are buying a lot of 10-year bonds, or both. In this case, it’s the increased demand for the bonds that is causing this, particularly from European investors who are getting a little skittish on their own economic prospects.

That is not something that bulls really want to see happening, but when it does, we do need to look to assess the damage. We don’t want to really put too much weight on something like this, because of the lag that we usually see with this, up to 2 years’ worth actually.

Some investors weren’t even spooked by the Great Recession, whether they should have been or not, but others may have various risk tolerances that can be exceeded by changing conditions. The ones we really need to worry about are the actual economic numbers, the actually appearance of recession, and much more importantly, how the market reacts to these changes.

Price is the ultimate arbiter of everything that relates to stock markets, measuring the actual reaction of the market to various things good and bad. We can tell ourselves that something is not really that big of a deal or actually should be helping the market not hurting it, but what the market decides is the final word on the issue, and the only real word actually, so we need to pay close attention to what happens in addition to what we might think happen.

Market Sentiment Overall Decides How Much Things Affect It

We can measure the overall sentiment of the market, which manifests itself in various degrees of positivity or negatively, and can say that for most of 2019, it’s been decidedly positive. The way to tell is to take a certain event, such as this one-day yield inversion, and measure the reaction. The more negative the reaction, the more the general sentiment is on the sell side.

We did start this week off in rebound mode, coming off the lows that we put in a couple of weeks ago, but this got transformed mid-week and we ended up moving back in a southerly direction. The fact that this started on a day where the Fed came bearing gifts to the market does tell us that a lot of investors are looking to find a reason to sell, and will even look pretty hard to find one, not that you ever need to look hard to find a reason to exit a position.

On Friday, while we may expect this news to have a bearish effect upon the market, this really was not of the magnitude that should produce a 2% decline if the market is leaning to the bullish side. It certainly can do this if we are leaning toward the bearish side, and when we stand on a downward slope, it doesn’t take much of a push to send us toppling.

The message here seems to be that investors are really starting to worry about this economic slowdown, and if they are worried, and are acting upon this worry, it doesn’t matter whether they should worry about this so much, they just do and that’s what drives prices, and the only thing that drives them actually.

The danger here is that by seeing people cash out their chips, that brings the price down, and if there isn’t enough desire on the buy side to counter and limit this, we could see more and more people joining the bears. This in itself can cause us to go down quite a bit, as we did last October for instance, and many other times throughout the history of the markets.

News does influence markets, but independent of this, there is always a dynamic going on behind the scenes of a more general nature. We only see the actual trades, and we don’t see how many people may be close to joining the selling should certain things happen, especially if the charts start looking less exciting. When we go down further than we may think, this tells us that the hidden bears may be more organized than we thought.

On Friday, we got to see that there does seem to be quite a few bears out there, with a lot perhaps hidden in the woods but ready to come out at a moment’s notice. This does not mean that investors should be joining them, but it would be wise to take heed of this if you are looking to cash in yourself and want to be ready when the tide really turns.

Luckily, the sort of risks we see in today’s market are more of a slow burning type, as the downside here is nothing compared to, for instance, the credit market crashing that we saw in 2007-2008. Slow means that we do not have to act with a lot of haste, and while there always is a time where you want to say no more, it’s just better when this happens more incrementally.

With what appears as market sentiment that is more sensitive to the downside though, we need to prepare ourselves even more. This could just be a temporary thing, but we also might be in for another ride downward to test the lows of early March, and we’ll have to see how the market responds next week to get a better idea, even though the odds are right now that next week may not be a positive one.