Crash Coming? 2007 and 1987 Patterns Emerging
Equity markets are getting uncomfortable, just below record highs.
Below is a chart of the S&P 500, which is tracked by the SPDR S&P 500 ETF (SPY) - Get Report for retail investors. After trending sideways for most of 2015, late summer proved painful for the market, showing declines by as much as 12%. Autumn has provided a relief rally, but this past week confirmed many of my suspicions. After retaking levels of nearly 2120, less than a percent off of record highs, heavy selling pressure ensued. No sector has been immune to declines, as even the stalwart Health Care Select Sector SPDR is down nearly 10% over the last few months.
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Last week, I wrote an article discussing my bearishness on the overall state of U.S. equity markets. I am not always pessimistic about the market, but I simply try to understand what the narrative is, and how the price action correlates.
U.S. equity markets have experienced a historic rise in recent years, fueled mainly by low interest rates and financial engineering by savvy corporate managers. Although there have been a few earnings superstars, such as Apple, largely the market has been buoyed by sentiment, as opposed to a strong underlying economy.
Right now, there are plenty more attractive short opportunities than there are longs at this point. When companies such as CVS Health and American Express begin to look enticing on the short side, you know something is fundamentally wrong. When preparing for declines, it is prudent to look at previous years, where large declines in major equity markets ensued.
Below is a chart of the S&P 500 in late 2007. After a strong rise higher in the years following the tech crash, the market finally ran out of steam. When the market runs out of momentum, negative stories that were once discarded on the way higher, finally begin to rear their ugly heads. In our current case, the narrative is China, commodities, and inflation; while in late 2007 it was the excessive use of credit. Rising lending rates are part of the narrative in both cases as well.
In 2007, the market broke trend in early autumn, and subsequently rallied higher, within a small percentage of its highs. The rally higher, however, proved to be merely a small rebound, quickly followed by nearly a year of declines into the depths of the financial crisis. It is unlikely we experience a decline of similar magnitude, but a 20% to 30% drawdown of broader equity markets is still possible -- and unwelcome.
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Furthermore, in 1987, shown below, just prior to the great crash, markets showed signs of weakness, followed by a subsequent rally to within a few percentage points of the highs. The market did end up turning lower, resulting in large declines for investors not willing to heed the signs.
Market declines should not be feared, for they are part of the price of doing business. Analysts that try to tell you that the market only goes up are naïve, and are ultimately adversely affecting the performance of your portfolio. I am currently long very few assets, and short many more. If you have the ability to sell out of positions, doing so would be beneficial as we enter a very uncertain terrain in coming months, where U.S. monetary policy will begin to tighten for the first time in nearly a decade.
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This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.