The China Drop – What Now for SPDR S&P 500 ETF Trust (NYSEARCA:SPY)

How unusual was last weeks' market action, and what does it mean for the future?

A chart of S&P 500 index volatility
S&P as viewed by its best and worst weeks

If you have been vacationing with the Amish, you may have missed it:  China has started sneezing, devaluing its currency, admittedly by letting the currency markets do it. The US Equity markets have certainly responded with alarm so far — with the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) losing 10% last week alone.  But where do we go from here?  Which sectors have been hurt so far the most, and which ones have pain in their future?  Is there any place to hide, and is hiding even a good idea?

History may not be any predictor of future results, but we use it when we decide to buy central heat in Minnesota. So, using history as a guide, how bad was this last week?

Looking Backwards…

A chart showing the largest rises and drops in the S&P 500 ETF (NYSEARCA:SPY) for the last 3 years
Good and Bad weeks for the S&P 500 for 3 years

Looking at the image above, it looks scary:  That pink line is the weekly change of the S&P 500 Index fund (NYSEARCA:SPY), with the blue and tan lines highlighting the worst and best weeks over a 3 month span.  Digging in, we see a bit more, though.  The market has lost 4% or more several times since 2012, but never more than 6% — until now (Image below).  So we should be alarmed, right?

Not so fast.  The first to do when confronted with the stock market being weird is to see if you can get more data, and look back further.  So we do that, going back to 1996, and we see that large drops are common, though few seem to be of the 10% or more variety.    But we also see that most of the biggest drops seem to happen AFTER most of the bear market has happened.  They also seem to be punctuated by large moves upwards (frequently right afterwards).


A chart showing the largest rises and drops in the S&P 500 ETF (NYSEARCA:SPY)
Good and Bad weeks for the S&P 500 from 1996

This argues (for me at least) for future good times in the market.  But where is the bear market?  We don’t see the fierce downturn that precedes these sharp moves downwards.  Normally, a move like this comes as the tail end of a bear market, and is called a climax.  Normally these climaxes move in the same direction as the market, just more strongly, and signal the end of the trend.  But the market’s been going up.  This violates our little paradigm.  What’s going on?

 

A chart that shows volatility in small caps from 1996 to present
A long term view of drops in an equal weighted basket of small cap stocks, rebalanced quarterly.

What about smaller cap stocks?

What happens if we consider a broader range of stocks?  The S&P 500 nominally has 500 stocks in it, but 50% of the index by market cap weight is in the top 50 stocks.  So, I ran the same chart on an “index” of all the companies in the Morningstar database that have market caps between $500 million and $10 billion.  I was definitely surprised — it had fewer extreme down days, and unlike the S&P 500, it didn’t break -10%.  But, it has had a fair amount of volatility recently, and made its last new high June 23rd.  If that’s a downtrend, then this climax downturn could signal the beginning of a new up rally.  That’s what happened Nov 23, 2011.  It also happened May 25, 2010, though with more sideways action.

A chart showing good and bad weeks for small cap stocks
A shorter term view of small cap volatility: good and bad weeks for that portfolio of companies between $500 million and $10 billion

So, I’m thinking that panic is misplaced.  I’m not sure I’d predict another huge bull market, but I’m not thinking the mattress is the right place for your cash, either.




SOURCEEquities Lab
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Henry Crutcher
Henry Crutcher is an avid family guy, board gamer (think Settlers of Catan, Puerto Rico, etc), computer nut, and all around geek. Hailing from Louisville, KY, he has noticed that the weather in Louisville is remarkably similar to the weather in Atlanta, GA despite the 407 miles that separate them. He has two daughters, one cat, and lots of trees. He loves the Miles Vorkosigan series from Lois McMaster Bujold, for its mix of SF, comedy and insight into how people work. He also comsumes more than his fair share of cheesy business/economics books, such as The Ascent of Money by Niall Ferguson, or Farewell to Alms, by Gregory Clark. He is CEO of Equities Lab, which enables individuals to invest the way hedge funds do.

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