Setting Up for 1987 Remake?

People are worried about the markets. No doubt – but in spite of that, they keep rising slowly. And every significant drop in the market is bought aggressively.

Those 2 sentences point to two bullish arguments:

  1. stock markets rise when investors are worried
  2. there is a lot of cash on the sidelines waiting to get in (even though maybe it gets out quickly)

So if you bought a generic large cap stock that pays a dividend, and just held, you’ve done rather well. In fact i have pointed out in numerous posts that buying income producing investments and holding made a lot of sense. I would break those investments down into:

  • Bonds
  • Dividend paying stocks (with a subset of large cap tech)
  • Preferred stocks
  • Master Limited Partnerships (MLP)
  • REITs

Our clients have had MLP, Preferred stock, and some REIT and dividend exposure all year (though not enough!).

However, I have been thinking lately of what could unfold in the markets over the next 3-4 months and 1987 comes closest to my mind.


Why 1987?

In 1987, the market had ground up all year. Interestingly, a lot of smart money felt there was too much hype in the market at the time. But it didn’t matter. Stocks were heading north.

Then October 19th happened. The autopsy came up with a cause – “Portfolio Insurance” which was a fancy term for “stop losses” created by a couple of professors. Since the idea was automatically selling if the marketĀ  fell, and since these sales were pre-programmed and automatic, once selling started the cascade began.

Today’s market is characterized by light volume and people tentatively adding longs all year (IMO). Volatility (VIX) is super low. People are very complacent at the moment. Despite the data showing investors are worried, those indicators have been swinging as wildly as the market as large market moves in short periods of time swing those indicators bullish and bearish in a matter of days.

Another characteristic of this market: there is a lot of short term trading (thanks Uncle Ben) which could also affect my thesis (I’ll explain below). So longs are tentative and many people these days use stops (very few pure fundamental investors out there). If the stops started kicking in and for some reason brought us to major support (where I’m sure ALOT of stops are), and it breaks through, it might be too strong for the buy the dippers to stop it short term.

If this does happen, I can see a temporary no-bid market falling straight down. Up until this point, the buy dippers have won, but some point, maybe near year end when people want to lock in profits, we’ll see a break.

Not 2007

Please understand, my argument is not a 2007-type argument. I am saying nothing here about underlying economic strength or fundamentals. I am simply critiquing with an idea that we may have Portfolio Insurance all over again only instead of a few large institutions, everyone one from big to small has stop losses (their own portfolio insurance) ready to fire.

Also, the market could snap back too – especially if central bank stimulus comes after the drop (one of my other theses). So this is not a call for a total collapse. Merely a short, violent and large correction due to widespread use of pre-programmed stop losses by individual and institutional investors. In all likelihood, I’d be buying after this!

Extent of Short Term Trading May Nullify My Thesis Too

Concerning the increase of short term trading – it may be that short term traders close out positions so extensively that by the time we get to major support levels, the selling is no longer strong enough to break through. And this might be what’s been happening. So if that is the case, my idea could be wrong.

This is one of those ideas that we’ll have to just see what happens. I’m not 100% in cash waiting for this but I’m also not buying extended stocks at this point either. And perhaps if more feel that way, that lack of buyers will contribute to the decline.