Happy Canadian Thanksgiving…Some historical perspective to digest with Pumpkin Pie.
In the current cycle, both the Russell 2000 small-cap index, and the capitalization-weighted NYSE Composite set their recent highs on July 3, 2014, failing to confirm the later high in the S&P 500 on September 18, 2014. Through Friday, the NYSE Composite is down -7.3% from its July 3rd peak, and the Russell 2000 is down -12.8%, while the S&P 500 is down only -4.0% over the same period. What’s happening here is that selling is being partitioned in secondary stocks, and more recently high-beta stocks (those with greatest sensitivity to market fluctuations). Market action is narrowing in a classic pattern that reflects the effort of investors to reduce risk around the edges of their portfolios, in what typically proves an ill-founded belief that a falling tide will not lower all ships.
See: Hussman’s, Air-pockets, free-falls and crashes.
And the downside mean-reversion needed to resolve present over-valuations and realign with historical experience is barely begun.
The disaster scenario is that some or all of these measures do not just revert toward their long-term averages but instead revert beyond their long-term averages — the way they almost always have before.
If we go from an era with spectacularly high stock prices, spectacularly low interest rates, spectacularly high profit margins, and spectacularly stimulative Fed policy to an era characterized by the opposite (like the 1970s), the sharp crashes and relatively quick recoveries of 2000 and 2008 will seem like brief, happy corrections.
It took about 25 years for the economy and market to correct the extremes of the 1920s. It took another 25 years to fully work off the (much lesser) extremes of the 1960s.
The extremes of the late 1990s, which have extended into the 2000s and, now, the 2010s, are, by some measures, the most extreme in history (including the 1920s).
It should not come as a surprise, therefore, if it takes us as long, if not longer, to work them off.
See: My disaster scenario for some excellent charts. This big picture view of the S&P 500 since 2007 shows the likely downside tests for this cycle.