When does the pleasure stop?

P.S. latest article here: http://statisticalideas.blogspot.com/2017/05/trump-bump-or-not-really.html

Markets have been on a smooth flight higher for nearly a year and a half now!  Sure we have had only a couple of the 5%-type of munchkin corrections since then, but that’s not enough, and we certainly have not had enough of the 10%+ crash variety that we would get much more often in the financial markets.  First this riskless performance was on President Obama’s watch.  Now it is on his successor’s watch.  Are things really that grand?  (No.)  Have we entered a new era worthy of unprecedented market bliss?  (No.)  We’ve recently shown that market volatility measure has been confined to the lowest quartile range, non-stop since before the election.  And we have only seen one 1%-down day since that election, and barely any multi-day corrections (or drawdowns) of worse than that 1% level.  Visualize this in the chart below for major unique crashes (not later subsumed).  Of course we characteristically see more risk action at all market correction sizes (i.e., more of the small corrections, and more of the large corrections).  So where did it all go?  Not to worry for those left behind by the run-up, the traditional convolutions of frequency and severity patterns shown here will guide you to the types of risk that still lay before us, from here to year-end!  This is not an April Fools' joke; and we reckon that the >5% YTD returns you just enjoyed could more than disappear at some point ahead.

In the next chart below we see a variety of different market drop levels, which can occur either over the course of a single day, or generally stretched across a multi-day period.  This time we examine major round-trip corrections, not small hiccups that are later subsumed in major corrections.  We elucidate this chart with some examples: there is a 71% chance that (before year-end) we will see at least 1 correction that is 5% or worse.  Could be a 15% correction, or could be two 10% corrections. And of course in some years (29% chance) we can go the remaining 3 quarters and see no such corrections at 5% or worse.  But we wouldn’t wager on this small chance of no 5% or worse corrections before year end.

The other example we demonstrate is a 32% chance that (again, before year-end) we will see at least 1 correction that is 14% or worse.  So not likely, but in 1 of 3 years we can expect to see such extreme corrections in a 9 month period (sometimes more than once!)   Is your Trumped-up portfolio ready for such sudden declines? 

Any level of correction is possible, and through history we noticed even larger sell-offs (2008 being a chief example and one that led to the TARP rescue program).  And for each market correction level (or worse), there are probabilities associated with them.  Of course even if one were to expect multiple corrections a year, this is simply on average.  This is not to suggest a guarantee of such a fixed number of corrections in any specific year.  Some years can have more corrections versus others.  And hence we shows this probability distribution for different risk frequencies (e.g., more likely to see 0 14% or worse drops than 1 14% drop … and 1 14% drop is more likely than seeing 4 5% or worse drops!)

What’s vital to take away from all of this is that stock prices very much move stochastically.  And a false narrative always ensues this random pattern, nothing more.  When the stochastics randomly reveal a recurring pattern, people’s belief in any reasonable fitted narrative becomes reinforcing.  But when we then see the pattern suddenly change, it then doesn’t seem right.  But of course it is right, since the market doesn’t care what you believe and it’s price changes are always random.  Never guided by narrative. 

When running TARP’s analytics team, we’d frequently see for government advisors that specific policy choices always happened to coincide with dramatic market moves.  Again this is a false causation and even a bad relation of any kind!  In recent years the market hasn’t responded to the same policy events.

No we have often admonished readers from taking leveraged positions in this market during this low-volatility period.  If one enjoyed the market run up until this point, then that’s fantastic.  But the easy money has disappeared.  Chances are it wasn’t you who made it.  Now there is more risk entering the fold, then there is money to be made.  There much to lose in the recent market run-up, if one joins right before it tumbles. 

A prompt once again that we haven’t seen enough, large or small corrections, since late 2015.  The market will give you a breather this year to get in at much better prices!