Comparisons to 1987

From Earnings Whispers. Can't link since it came via email.

There has been a lot of talk among traders of late comparing 2018 to 1987, primarily due to the extreme levels of optimism and a strong rally at the beginning of the year. 1987 ended with a stock market crash so, the way we see it, the more people make the comparison the less likely 2018 will see stocks decline. However, there is one troublesome comparison to 1987 that we’ve kept an eye on for several months now but it is just beginning to play out.

Recall back in 1987 the stock market peaked that July just before Paul Volcker was replaced by Alan Greenspan at the head of the Federal Reserve in August. One of the first things Greenspan did was tighten liquidity, which ultimately resulted in the stock market crash shortly after in October. Fast forward to today with Jerome Powell taking over the helm of the Federal Reserve from Janet Yellen. Powell is generally considered to be a like-minded Fed Governor and just as overall dovish as Yellen, but the Fed has been taking liquidity out of the market as Yellen ends her term, so more of the same from Powell likely should be viewed as bearish for stocks.

We don’t have the data available to us going back to 1987, but the chart below shows the Fed’s primary means of adding liquidity over the past decade and a half – through Treasuries and mortgage-backed Securities. From the stock market’s bottom in 2003 until the top in 2007, the Fed was a buyer of assets, but when the housing market became too frothy, the U.S. Dollar fell, and commodity prices spiked, the Fed started to sell its holdings of U.S. Treasuries, which took liquidity from the market and an eventual stock market crash. At the bottom of the stock market in 2009, the Fed started buying a massive amount of both U.S. Treasuries and mortgage-backed securities. The result was an ample amount of liquidity for the market that eventually found its way into stock prices.



For almost a decade now, there were times where the Fed was on hold or did things such as “Operation Twist”, which basically just moved assets around and was net-neutral for market liquidity. Now, however, the Fed is unwinding its assets, which creates risk to market liquidity and stock prices.

The chart below is a closeup of the previous chart to highlight the more recent decline in the Fed’s balance sheet. Thanks to the unwinding of both U.S. Treasuries and mortgages last week – the largest single weekly decline in the Fed’s balance sheet since operation twist – the Fed’s holdings have now declined over the past four months more than at any time since 2008 with nearly half the decline coming last week alone. Which helps explain the massive selloff in stocks we saw on Friday.



We’ve known the Fed has planned to unwind its holdings of U.S. Treasuries and Mortgaged-backed securities and we’ve known this would likely take liquidity from the markets, but since the tapering started in October the Fed’s actions have been inconsistent. Furthermore, we’ve seen new money come into the stock market in anticipation of the tax reform. As the Fed’s holdings dropped last week though, we saw money come out of the market. Our strategy was to remain long while the S&P 500 held above 2,800 but on Friday the index gapped to the 2,800 level, taking us out of many of our long positions and apparently many others as well.

The chart below shows the S&P 500 and the indicated near-term trading range based on the price action. As the stock market sold off today, we’ve had to rewrite this discussion because the downside target has been hit – selloffs tend to be much faster than rallies – and so now our focus shifts from leaning more towards shorting stocks to now looking to trade swings on the long side and look for a new signal.



Perhaps the real story though is the CBOE Volatility Index (VIX), which was more than four standard deviations above the 20-day moving average for only the fourth time in the history of the data. The CBOE started providing real-time VIX data in 1993 but provides historical data going back to the start of 1990 and the very first time the VIX closed more than four standard deviations above the 20-day moving average (the upper Bollinger Band) was in August 1991 during the Soviet August Coup. The S&P 500 ended up trading down approximately 5% from its recent high but around a week later was back at its high.

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The VIX didn’t have another similar spike for more than 15 years, but towards the end of February 2007, the S&P 500 sold off more than 3% and the VIX spiked. The S&P 500 moved lower over the next few sessions but six weeks later the S&P 500 was back at a new all-time high. Then, this past August following turmoil with Korea, the VIX spiked again. The S&P 500, after selling off with the spike in volatility, went on to trade even lower a week later, but this proved to be a buying opportunity before the S&P 500 made a new all-time high a month later.
We are not necessarily calling for a similar move to new highs this time, especially based on just three prior occurrences, but the change in trading strategy following Friday’s move likely needs to be revised once again on Tuesday.