If it is not already
happening, someday soon some entrepreneur will start selling t-shirts
proclaiming “I Survived the Great Stock Panic of 2008”. The
last few months’ market action has been so unprecedented, and so
brutally unforgiving to trade, that emerging from it ready to keep trading is
an impressive feat. Many traders have lost everything because of their
leverage while many more have totally given up on trading.
As a speculator, I
found this stock panic very painful like everyone else and I can’t wait
for the markets to resume some semblance of normalcy. But as a student
of the markets, the last few months were the most fascinating I have ever
witnessed. People are going to be talking about and studying the Great
Stock Panic of 2008 for generations. Yet we got to live through it and
witness its fury firsthand in real-time!
This panic’s
broader stats, seen through the lens of the flagship S&P 500 (SPX) stock
index, defy belief. In less than 4 weeks in October, the SPX plummeted
27.1%. With the various circuit breakers implemented after the infamous
1987 crash (20.5% in a single day), I didn’t think such a fast selloff
in the biggest and best US companies was even possible anymore. Yet it still
happened despite the mechanisms designed to retard a panic.
In less than 3 weeks
in November, starting the morning after the US elections, the SPX plunged another 25.2%. Overall
from late August, US stocks fell an unthinkable 42.2% by their November 20th
lows! Reading these sobering stats, you’d think this would have
been a shorting paradise. But the great majority of the shorts were
slaughtered too. This panic was so hyper-volatile that successful
directional trading betting long or short was nearly impossible.
Volatility, or the
amplitude and frequency of daily moves in the stock markets, is fascinating
to study. Excessive volatility is a double-edged sword, offering
traders both great opportunities and big risks. To help my own trading,
I have done many volatility studies covering many markets in the past. Back
in March 2008, after the SPX’s biggest daily rally seen since October
2002, I researched SPX volatility.
Volatility studies
help illuminate the probabilities underlying big daily moves, the knowledge
of which can really help traders. If you know how likely in the past a
given up or down day has been in the SPX, and you see one today, you can
better understand how to trade it. If it is very rare, odds are the
trend that big day capped is likely to reverse, at least for the short
term. Knowing this, you can trade accordingly.
In my March study, I looked at the
SPX’s daily moves going back a decade or so, to 1998. I found
that truly huge moves by SPX standards ran 4%+ in either direction. From
January 1998 to March 2008, there was just a 0.4% chance of seeing a giant
4%+ up day and a 0.2% chance of seeing a giant 4%+ down day. In other
words, 99.4% of the SPX days over this span had less than 4% close-to-close
swings.
With the SPX
dominated by elite blue-chip stocks, it just wasn’t particularly
volatile. Kind of like comparing oil supertankers to speedboats, large
market-cap companies just can’t move as fast as small-cap ones. And
as of early May before this latest selling started, the ultimate blue-chip
elites of the Dow 30 dominated the SPX. These 30 companies, 6% of the
SPX’s listings, made up a whopping 34% of its market cap.
So over many decades,
a perception of safety in large caps developed. While they would indeed
fall in a bear market, they shouldn’t fall particularly fast. Investors
relied on their relative price stability. But provocatively the Great
Stock Panic of 2008 radically redefined what is possible in SPX
volatility. Elite large-cap stocks bounced around with dizzying speed
and ferocious intensity. It was crazy.
Trying to understand
this panic’s extreme volatility as a whole, I made this first chart.
Since 4%+ days were exceedingly rare in my earlier SPX volatility study, I
decided to label all the 4%+ days since May. They barely fit there were
so many! While I attempted to trade through them all, this strategic
perspective really drives home just how extraordinary this panic was. Extreme volatility literally
became the panic norm.
Between September
15th and December 2nd, a short 56-day span, there were no fewer than 27 4%+
daily close-to-close moves in the SPX! This is a staggering 48.2% of
the days compared to just 0.6% of the days in the decade before March
2008. So if you had a tough time trading this chaos like me,
don’t feel too bad. No one has ever seen anything like this
before. It was the mother of all stock-market anomalies.
15 of these 27
goliath moves were down days with 12 being up days. This is only
56%-to-44% in favor of big down days in this hyper-volatile time, which is kind
of surprising considering how far the SPX plunged in this panic. As you
can see in this chart, big down days (or a couple of them) were usually
followed immediately by big up days. This created unprecedented
choppiness that killed all directional trades.
The modern S&P
500 stock index wasn’t launched until March 1957, but it was
back-calculated to 1950. Sometimes on CNBC you’ll see analysts
discuss SPX action before 1957, but they are mistaken. Prior to 1957
the S&P 90 was the equivalent index, and it is sometimes appended to the
S&P 500 to take the data back to 1918. But in strict terms, what we
know as the S&P 500 today has only been around for 51 years.
The biggest
historical study possible of this index includes the back-calculated data to January
1950, almost 59 years of daily trading. Considering that the average
investor’s investing lifespan is probably 40 years between first having
material surplus capital to invest and then retiring, nearly six decades is a
lot of data. I combed it all, trying to understand just how
unprecedented this panic volatility truly was.
Incredibly, 6 of the
SPX’s 10 biggest up days ever happened since September
30th! They are all labeled above with the numbers in circles next to
the percentages starting at the best SPX day ever, October 13th’s epic
11.6% surge. Since big up days tend to mark V-bounces kicking off major
bear rallies, and this was the biggest up day ever, I started betting heavily
long in mid-October. But boy this panic humbled me, continuing lower
even after such a once-in-a-lifetime daily rally.
5 of the SPX’s
10 biggest down days ever also happened since September 29th. October
15th’s 9.0% loss, December 1st’s 8.9% loss, and September
29th’s 8.8% loss came in 2nd, 3rd, and 4th respectively as the biggest
daily selloffs ever after the notorious October 19th, 1987 crash. When
6 of the 10 biggest up days and 5 of the 10 biggest down days in history all
cluster together within a tight 45-trading-day span, you know we just
witnessed something special that will probably never be seen again.
This panic was unique
even among stock panics. If you are interested in why it happened, its
driver, I discussed that in the current issue of our Zeal
Intelligence newsletter. But the result of such insane
volatility is that all traders got crushed. Historical market
knowledge, time-tested indicators, contrarian bets against popular sentiment,
nothing worked in this panic. It was the most challenging
environment ever.
When discussing
volatility, we can’t overlook implied volatility. So I included
the VXO S&P 100 implied volatility index in the chart above. The
panic started in late September when the VXO went over 50, the traditional
fear apex even in severe bear markets. Yet this time fear
climaxed over 80 several times, levels that defy belief. And
this panic won’t end until the VXO falls under 50 and stays there once
again.
Encouragingly, fear
is abating as represented by the VXO. At its current pace of decline,
it won’t be long until it falls under 50 again and this panic
ends. We humans are remarkably adaptable. Put us in a bad
situation, no matter how unpleasant, and it doesn’t take us long to
adapt to it. Market conditions that terrified traders in early October
have now grown kind of routine. We are all growing numb to extreme
volatility, which really undermines fear. And once fear starts
evaporating rapidly, this panic is over.
And since panics
drive stock prices to irrational and unsustainable lows, when this panic ends
we are likely to see a monster rally. It may just be a mighty bear
rally, but it may also prove to be a new cyclical stock bull within this secular bear.
I suspect the latter, given the ridiculous levels of fear this panic
generated. And if this proves to be the case, now is a great time to
add heavy long exposure in beaten-down stocks. My favorite sector in
which to ride this coming rally is the incredibly oversold commodities stocks.
Back to the task at
hand, I built a couple histograms to better understand the amplitude (how
big) and frequency (how often) of SPX daily moves in normal conditions as a
baseline and then in the Great Stock Panic of 2008. This first chart
shows the distribution of all SPX trading days between January 1950 and
August 2008. Until you understand this baseline, you can’t
comprehend how extraordinary the panic was.
These bars are
inclusive for their integer, so the +1% bar for example includes all daily
gains between 1.00% and 1.99%. As you can see, the great majority of
the SPX days, 79.2%, were what I have long considered
“unchanged”. Unless the SPX moves by 1%+ in either
direction on a given day, I consider that day in isolation pretty
irrelevant. Sub-1% moves (when not considered as part of a trend) are
random noise.
And while unchanged
days are common, big moves are very rare. This distribution is
normal and expected, and forms a classic statistical bell curve as the yellow
line connecting the bars illustrates. Due to monetary inflation and
real economic growth generally driving stock prices higher over decades, this
bell curve is positively skewed. Unchanged up days are much more likely
than unchanged down days.
Indeed the stock
markets are pretty sedate most of the time. Sometimes years can
pass between episodes of notable volatility. But don’t forget
that even though most of this 14,760-day span since January 1950 was calm, it
had plenty of famous episodes of fear and volatility. It encompasses
the 1966-to-1982 secular
stock bear, the brutal 1973-1974 cyclical stock bear culminating in the October 1974
stock panic, the infamous 1987 crash and its aftermath, the 1998 financial
crisis spawned by the Russian debt default, and the nasty early-2000s
cyclical bear. Countless mini-selloffs also dotted this long span of
time.
Despite all this
history, so much turmoil, prior to the Great Stock Panic of 2008 the SPX only
saw 24 days with gains greater than 4%. This works out to a trivial
0.2% probability. And there were only 18 days that saw losses of
greater than 4%, 0.1% of all days. Big 4%+ daily moves are exceedingly
rare. So no matter how much you knew about market history, that knowledge
couldn’t prepare you for this panic.
So if you are mad at
yourself for not trading an unprecedented anomaly well, you are wasting your
time. If you are angry with a professional managing your money for
getting hit, realize everyone was killed in this panic. No matter where
you had capital (in stocks) you still would have gotten hammered. Like
for a sudden tornado spawning out of nowhere, the only course of action is to
weather it, survive, and keep on trading after it passes.
I built a second histogram
that illustrates the daily moves distribution from September 2008 to today,
only in the Great Stock Panic of 2008. Of course I realize this is not
quite an apples-to-apples thing to compare an exceedingly long period of time
to an exceedingly short one. Nevertheless, it is very relevant.
And if the percentages bother you, the absolute number of days that giant SPX
moves occurred will not.
This mess is about as
far from a normal bell curve as you can get. Giant days, both to the
upside and downside, were as common as unchanged days during this
panic. I superimposed the same yellow bell-curve line from the earlier
pre-panic-SPX-history histogram on top of this one for comparison. This
wacky distribution just drives home how weird this panic truly was. No
one has ever seen anything like it before.
Compared to a
historical probability of 0.2%, during this panic 16.9% of the days had 4%+
daily gains. Compared to 0.1% since 1950, in the last few months 21.1%
of the days had 4%+ daily losses. You could try and argue this away
based on the vastly shorter sample time of this panic compared to the entire
SPX history before. But the raw numbers of days quickly short-circuit
any such effort to downplay this event.
Prior to September
2008, the SPX only had 24 days with massive 4%+ gains. Since September,
we’ve seen 12 more such days! On the downside, before this panic
the SPX only had 18 days in its history with huge 4%+ losses. During
this panic, we’ve witnessed another 15 days! We are talking about
58+ years here compared to about 3 months. Over this short panic
span, the 4%+ up days grew by 50% and the 4%+ down days grew by 83%! This
panic volatility was off the charts, totally unpredictable based on history.
Certainly
interesting, but what do you do with this knowledge? There are a couple
primary applications. First, as I discussed earlier, no one has ever
seen anything like this event before. And even if you were bearish and
short, as I was between January and early October,
the hyper-volatility made it nearly impossible to launch profitable trades in
recent months. Nothing works in such extreme choppiness.
So it is pointless,
and destructive, to second-guess your trades made in September and early
October when the markets still appeared to be guided by historical
precedent. There is really no way to prepare for an event never before
witnessed. All trading is based on history to some extent, gaming norms
established over decades. But when those norms suddenly blow apart,
virtually all trades are going to simultaneously blow up. Prudent
traders can’t live in constant fear of some unthinkable event.
For decades
now, peripheral fears have existed that debt was unsustainable so a collapse
was coming. Remember that book “Bankruptcy 1995: The Coming
Collapse of America” from the early 1990s? It highlighted deep,
and very real, structural problems in American debt (public and
private). Yet time has proven it would have been irrational to pull out
of the markets because of it. One would have missed the tech boom of
the 1990s and then the commodities boom of the 2000s, both exceedingly
profitable bulls.
Rome gradually waned in power for
centuries before falling, and Great Britain has been a fading power for
the better part of a century now. While we do have plenty of big
problems in the US, and the locus of global power is gradually slipping away,
our fall probably won’t happen fast. The point here is there are always
end-of-the-world-as-we-know-it theories on the edge of the markets that
implore you to sell everything and never come back. Yet somehow the
markets continue to function just fine and people generate great wealth.
A stock panic is
scary, but it doesn’t mean the end of the world. Nor a coming
depression, as I discussed in depth in the new issue of Zeal
Intelligence (free for first-time e-mail-PDF-edition subscribers). During stock
panics, irrational fear spirals out of control which drives stock prices to
unthinkable lows. But as soon as rationality returns, stock prices
recover. Which brings us to the second application of this
extreme-volatility knowledge.
Extreme events like
this are extreme simply because they don’t happen very often.
So when one does happen, the biggest mistake to make is to extrapolate it out
into infinity. We have a natural human tendency to do this, to assume
the present is going to be the new norm for the future. You see this
all the time after natural disasters. Some small town hasn’t had
a big flood in 500 years, then they have one, so all of a sudden the
residents are all paranoid and cower at every rain drop. They expect
more 500-year floods constantly.
Obviously this is
highly irrational. After an exceedingly-low-probability event, the odds
of another one in the near future are virtually nil. The hyper-extreme
volatility we’ve witnessed in the stock markets in the last few months
doesn’t mean it will continue forever into the future. Much more
likely after such a crazy event we won’t see another one in our
lifetimes. The markets hate extremes and always revert to means after
one. After such a panic, this means radically reduced volatility and a
major stock-market rally.
At Zeal we too
certainly took our lumps in this panic, it wasn’t fun from an investing
and speculating standpoint. Nevertheless, we refuse to let herd
mentality override cold rationality. The extreme volatility is already
abating, and after such a massive fear event a major rally to bleed off the
fear is almost certain. Thus we are positioning our capital
accordingly, launching new trades particularly in beaten-down commodities
stocks to ride the coming rally.
Join us today! Subscribe to our acclaimed Zeal
Intelligence monthly newsletter to capitalize on an event so rare
that no one has ever seen it before. The sheer levels of fear driven by
such volatility were so irrational on the downside that the subsequent upside
will probably end up breaking a lot of records as well. Betting long
during a stock panic is the ultimate high-potential contrarian play!
The bottom line is
the stock volatility witnessed during the Great Stock Panic of 2008 was off
the charts. It was literally unprecedented even for a stock
panic. Never before have the stock markets been so volatile, and so
unforgiving, for so long. But the very extremeness of this episode
argues strongly against its sustainability. The markets abhor extremes
so hyper-volatility must yield to normal and then low volatility.
If you can take the
long view, suppress your own emotions and ignore the mainstream herd’s,
the opportunities presented by this stock panic are vast beyond belief.
Since there is blood flowing in the streets, and no one wants stocks,
fortunes will be made by the brave few contrarians willing to buy when
everyone else is selling. I am going to be one of them, and you can be
too.
Adam Hamilton, CPA
Zealllc.com
November 21, 2008
So how can you profit from this
information? We publish an acclaimed monthly newsletter, Zeal
Intelligence, that details exactly what we
are doing in terms of actual stock and options trading based on all the
lessons we have learned in our market research. Please consider joining
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Intelligence service at … www.zealllc.com/subscribe.htm
Questions for Adam? I
would be more than happy to address them through my private consulting
business. Please visit www.zealllc.com/adam.htm for more information.
Thoughts, comments, or
flames? Fire away at zelotes@zealllc.com. Due to my
staggering and perpetually increasing e-mail load, I regret that I am not
able to respond to comments personally. I will read all messages though
and really appreciate your feedback!
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Research (www.ZealLLC.com)
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