Anatomy of a market correction

How does a market correction unfold? There are often a number of discrete steps, as illustrated below by the S&P 500 in 2006 :

Step 1: Nothing has fundamentally changed: Nothing, that is, except the street's P/L, and concomitant change in psyche

Step 2: Whew, glad that's over: See, I told you nothing had changed fundamentally!

Step 3: Oh *%&$: What, another call from the margin clerk? And don't these idiots know what a great story Brazil is?

Step 4: Time to be clever: I've learned my lesson; this market's going down forever. I'm gonna use this bounce to go short.

Step 5: Look how smart I am: See, I told you the market was going down. It just needs to go a bit further...

Step 6: How dumb is this market? This bounce is waaayyyyy overdone. Don't people realize that the bull market is over?

Step 7: Oh *%&$: Time to cover shorts and go long again!

Macro Man reckons we are phasing from step 1 to step 2. He was perhaps a bit early in making that call yesterday with respect to the US, but Asia has behaved according to plan. The 6.6% peak to trough decline in the SPX has exceeded the initial move in 2004, 2005, and 2006.

The P/L has suffered, but some of that is basis risk: the alpha trades are reflecting the bounce in Asia, but the SPY beta position clearly does not.

Past performance indicates that step 2 usually lasts 1-2 weeks and can retrace a significant portion of the initial downleg in risk assets. A useful reference point is a medium term moving average such as the 40 day or the 55 day in the SPX, which currently lie at 1431 and 1428, respectively.

For choice, Macro Man would expect rallies to fail at those levels, perhapos reaching a maximum of 1415-1420 instead. Regardless, Macro Man wants to be prepared and have plenty of room in the inn for risky asset shorts as step 2 matures and begins to phase into step 3.

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Click here for comments
March 6, 2007 at 12:49 PM ×

Bonds have under-reacted in comparison with last May. One could imagine central bankers thinking about taking advantage of the current chaos to rid themselves of their presumed responsibility to shore up risky markets,... especially if a certain new face wanted to distinguish himself from his predecessor.

Macro Man
March 6, 2007 at 1:43 PM ×

I don't think it's altogether surprising that bond performance has been different; after all, last May started as an inflation/credibility issue (remember Bartiromo-gate?) , whereas currently we have a growth scare.

What people do appear to agree on is that the so-called 'strike of the Bernanke put' is condiserably further out of the money than the Greenspan put used to be. Then again, Bernanke was drinking sherry in an ivory tower in 1987 and 1998...

March 6, 2007 at 3:35 PM ×

I thought it started because, sitting in for Abelson on May 6th, one Randall Forsythe took AADWS cotton-candy bullish... for the first and last time.

March 6, 2007 at 9:54 PM ×

Ouch, ouch, that squeeze hurts! Went short some more at 3.55 pm, gritting teeth, waiting for "phase 3". Will go short till broke on upswings. This is nerve wracking. Maybe I should be out playing shuffleboard like my wife said. OldVet