On The Origin Of Crashes & Clustering Of Large Losses

Abrupt market losses typically reflect compressed risk premiums that are then joined by a shift toward increased risk aversion by investors. In market cycles across history, we find that the distinction between an overvalued market that continues to become more overvalued, and an overvalued market is vulnerable to a crash, often comes down to a subtle but measurable shift in the preference or aversion of investors toward risk – a shift that we infer from the quality of market action across a wide range of internals. Valuations give us information about the expected long-termcompensation that investors can expect in return for accepting market risk. But what creates an immediatedanger of air-pockets, free-falls and crashes is a shift toward risk aversion in an environment where risk premiums are inadequate. One of the best measures of investor risk preferences, in our view, is the uniformity or dispersion of market action across a wide variety of stocks, industries, and security types.
Once market internals begin breaking down in the face of prior overvalued, overbought, overbullish conditions, abrupt and severe market losses have often followed in short order. That’s the narrative of the overvalued 1929, 1973, and 1987 market peaks and the plunges that followed; it’s a dynamic that we warned about in real-time in 2000 and 2007; and it’s one that has emerged in recent weeks (see Ingredients of A Market Crash). Until we observe an improvement in market internals, I suspect that the present instance may be resolved in a similar way. As I’ve frequently noted, the worst market return/risk profiles we identify are associated with an early deterioration in market internals following severely overvalued, overbought, overbullish conditions.
With respect to Federal Reserve policy, keep in mind the central distinction between 2000-2002 and 2007-2009 (when the stock market lost half of its value despite persistent and aggressive Federal Reserve easing), and the half-cycle since 2009 (when Fed easing relentlessly pushed overvalued, overbought, overbullish conditions to increasingly severe and uncorrected extremes): creating a mountain of low- or zero-interest rate base money is supportive of risky assets primarily when low- or zero-interest rate risk-free money is considered an inferior holding compared with risky assets. When the risk preference of investors shifts to risk aversion, Fed easing has provided little support for prices (see Following the Fed to 50% Flops), which is why we believe it is essential to read those preferences out of the quality of market action.

This post was published at Zero Hedge on 10/20/2014.