Lessons from ”Black Monday”

August 24, 2015: Stock prices in China’s Shanghai Exchange had the biggest one-day fall of nearly -9% since 2007, earning that event the title of “Black Monday”. Exchanges around the world followed suit. Next day, the Shanghai crashed below -15% (ref 1,2). Stunned investors worried about sliding into a bear market, then into a recession. Crashes, bear markets, and recessions produce losses of investment earnings. What are they and how do they occur?

Cycles

The stock market is one component of the larger economy. Both systems expand and contract in cycles governed by the net influence of buying and selling in diverse markets. Stock market cycles are gaged by real-time and historical stock prices. The real-time prices fluctuate according to traders’ demands for shares at any moment in time. The historical prices are chosen from four real-time prices: the Open and Close are the first and last prices of the trading day”; the High and Low are maximum and minimum prices of the day; and, the adj Close is an adjustment of the Close to account for a cumulative effect of stock splits and dividends.

Stock prices are compiled into market indices.  A market index measures the collective value of prices from a given group of stocks. The index Close changes from day to day, but when successive Closes are strung together over a period of weeks to months they form an observable trend called a market cycle. In chart 1, the market cycles of two indices are plotted over 25 years. Both plots show that the collective value of stock prices expanded in three “Bull markets” (1990-2000, 2003-2007, and 2009-2015) and contracted in two “Bear markets” (2000-2003 and 2007-2009). Orange circles identify recent trends and events leading up to the writing of this post on September 11, 2015.

chart 1

chart 1

Long market cycles

A long market cycle is comprised of a bull market and bear market (ref 3).
Bull market– a period of rising prices, by 20% for at least 2 months
Bear market– a period of falling prices, by -20% for at least 2 months

Short market cycles and brief events

Short cycles and brief events are tremendously exciting interruptions of the long market cycle. They represent an extraordinary change in market behavior caused by flows of investment capital or responses to influential news.

The short market cycle is either a rally or correction. Both are brief changes in the Close that interrupt a bull or bear market.
rally– an increase in stock prices due to a burst of buying that subsides when the money is spent.
correction– a 10% price decline (ref 3).

Spikes and crashes are brief events . Both are characterized by a large, sudden shift of the index value from its previous Close.
Spike– a large upward or downward price movement (ref 3)
Crash– a 10% decline in market value lasting 1-2 days (ref 4)
Crashes are precipitated by the sellout of inflated stock prices. Chart 2 shows both a correction and a crash of the NASDAQ Composite Index during the six-month period leading into September 11, 2015. Blue squares depict the daily Close of the NASDAQ. There was a 4-week correction of –13.5% (solid black line) from July 17th to August 25th. The 12% crash (dashed red line) occurred between the Close of August 21st and the Low of August 24th (the market was closed on 2 intervening days). August 24th was “Black Monday”.

chart 2

chart 2

Circuit breakers

Circuit breakers are automatic pauses in trading that enable market participants to evaluate their trading orders in a rapidly changing environment. SEC Rule 80B defines the following halt provisions and circuit-breaker levels that impose a pause on trading (ref 5):
• the S&P 500 is the benchmark index for measuring a market decline below the prior day’s closing price
• 7%, 13%, and 20% market-decline percentages initiate trading pauses of 15 min, 15 min, and rest of the trading day.

Business cycles

Business Cycles are broad fluctuations of business activity that affect the entire economy. The total value of business production is measured by the gross domestic product (GDP). The Real GDP is “the value of the goods and services produced by the nation’s economy less the value of the goods and services used up in production, adjusted for price changes” (ref 6). The main components of GDP are personal spending, investment (e.g., the stock market), net exports, and government spending (ref 3). Swings of the GDP are produced by the net buying and selling within these business categories. An upswing signifies economic expansion and a downswing signifies economic recession. Expansion is the default mode of the economy that typically outlasts a recession and ends when overproduction leads to general economic decline. Recession (ref 3) is the decline in economic activity lasting about 6-18 months. Interest rates usually fall during a recession and stimulate the next expansion by easing the cost of borrowing money. In technical terms, a recession is 2 consecutive quarters of decline in the GDP (Chart 3).

chart 3

chart 3

While a recession occurs with every business cycle, depressions happen very infrequently. A depression is an extreme fall in economic activity lasting for a number of years. In a depression, consumer confidence and investments decrease as the economy collapses (ref 3).

Economic Recovery is the period of increasing business activity signaling the end of a recession (ref 3). Similar to a recession, an economic recovery may be unrecognizable for the first several months. The stock market may be a leading indicator of economic recovery because stocks are priced on the basis of future expectations. Unemployment often remains high in early recovery until employers determine the long-term need for hiring.

Conclusion

Market sentiment is “the overall attitude of investors toward a particular security or larger financial market” (ref 3). Investors become optimistic (“bullish”) during a bull market and pessimistic (“bearish”) during a bear market. Optimism encourages stock purchases and pessimism stimulates stock sales. Crashes generate panic and a rush to sell stocks in the declining market.

Opportunistic investors incur an upside risk and downside risk when timing the market cycle for profitable trades. The upside risk is a gain in profit by selling shares at a high price and buying them at a low price at the appropriate time. But don’t bet on it, especially not with big bets. Successful timing requires a big dose of good luck and crashes are always unpredictable. Conditional trading orders may be helpful in timing the market if a limit price is included in the order; otherwise, any unexpected market event could trigger an undesired order. The best upside risk in a bear market or economic recession is taken by buying good stocks of financially stable companies at low prices.

The famous downside risks of a recession are speculative buying and frustrated selling. Speculators, beware of the falling share prices of high-risk stocks. The worst possible outcome is to suffer a steep capital loss by repeatedly purchasing shares until the recession drives an unstable company into bankruptcy (I know from personal experience). Some frustrated investors suffer a steep loss by selling out a good stock at bottom prices, only to miss the eventual recovery of their investment earnings after the recession.

Copyright © 2014 Douglas R. Knight

References

1. Financial markets. The Great Fall of China. The Economist, page 11, Aug 29th 2015 |
2. Briefing, China and the world economy. Taking a tumble. The Economist. Pages 19-22, Aug 29th 2015.
3. Investopedia Dictionary. www . Investopedia . com / terms. © 2015, Investopedia, LLC.
4. Kimberly Amadeo. Stock Market Crash. What Not to Do in a Stock Market Crash. © 2015 About.com. http://useconomy.about.com/od/glossary/g/Market_Crash.htm
5. SECURITIES AND EXCHANGE COMMISSION. (Release No. 34-68784; File No. SR-NYSE-2013-10), January 31, 2013. https://www.sec.gov/rules/sro/nyse/2013/34-68784.pdf
6. U.S. Department of Commerce. Bureau of Economic Analysis. Gross Domestic Product. http://www.bea.gov/

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