Discounting One Day Stock Market Crashes

The Reformed Broker has asked various bloggers to finish the sentence “In 2009 I learned that …” His compilation will be up tomorrow. It made me take a step back and think about what I learned in 2009. My response is below.

In 2009 I learned that the fear (or hope) of a one day market collapse is an erroneous psychological bias that many traders harness to their detriment.

People are obsessed with market crashes like all disasters. Yet, from 1899 forward, there have only been 3 days that the market has been down over 10% in a single day (see Wikipedia chart below). Crashes and corrections usually do not happen in one day. Traders with a long bias typically have time to get out before major damage is done. Traders with a short bias will likely have time to short the market into a sustaining decline. So why were so many intelligent traders waiting for the big drop? And why did so many of these intelligent traders either fail to climb the wall of worry or short the market into the rally? We were conditioned in 2008 to believe that one day market crashes were a regular occurrence. Four of the top 20 biggest single day drops came in 2008.

How do we manage this bias?  One thing to keep in mind is that these events are rare and almost always come with warning.

By the time September 29, 2008 (the first big 2008 drop) arrived, the VIX was already around 35. The market was also trading below its 200-day simple moving average.

Interestingly enough, before September 11, 2001 the market was already declining and below its 200-day simple moving average. On September 10, 2001, the VIX closed at 34.

I don’t have VIX data for October 19, 1987 (Black Monday), but I can tell you that $DJI broke its 200-day simple moving average on October 15, 1987 prior to Black Monday. The market also gapped down on October 16, 1987 just in case a strong hand was not compelled to sell on October 15, 1987.

The Asian crisis in 1997 did come about without sirens blaring. The Dow tanked 7.18%.  The VIX was elevated at 26 but still within its range.  The market was also trading above its 200 day simple moving average prior to the decline. While a 7.18% decline is quite scary (it likely means at least a 10% loss for a fully invested non-levered all long portfolio), it was not a wipe out event like Black Monday. Moreover, the cost of trading without this fear does have a price. A one day event could happen (e.g., Israel bombs Iran, Russia deploys troops to Iran in response) . It just seems to me that the benefit of dismissing this possibility greatly outweighs all the long term costs of factoring this into your trading.

My conclusion is that other than the Asian crisis in 1997 these big drops came with a loud warning. Be vigilant if the market is trading below its 200-day simple moving average  combined with a VIX north of 30. In fact, these are often great times to think about shorting the market.  Ignore the noise of doom and gloomers if these conditions do not exist. I’m somewhat of a doom and gloomer myself. I think the doom and gloomers are generally a smart bunch. Ultimately the Karl Denninger types will likely be right. But with the market, timing is everything. The ills of today may not come to fruition for many years. I think there is a lot of truth to the statement that short sellers arrive early (and so often get thrown out before the market does actually move lower).

By the time May/June 2009 rolled around (above 200 day, VIX below 30), the fear of a drop without warning should have been discounted. Yet many to this day keep waiting for the big drop out of nowhere. History says that it will not happen out of nowhere.

So my takeaway from 2009 is to dismiss the one day crash. If you don’t, you are paying a hefty price. On the long side, you’re likely giving up performance by closing positions early or sitting on the sidelines in fear of the big crash. If you’re trading short, you may be exposing yourself by being too early or you might simply be waiting forever for an event that does not occur (or being short into a huge rally like many have been in 2009).

I’m willing to operate under the assumption that if the VIX is below 30 and SPY is above its 200-day simple moving average that a one day move down of greater than 5% is extremely unlikely and that a double digit move down is statistically almost an impossibility (it would take a major exogenous event that government intervention could not control). Just like longs should not fear the single day crash, shorts should not fret over the lost opportunity of missing a major correction. Take a look at 1929, 1987, 2001 and 2008. There was plenty of time to build a short position before the bigger drops. These were not one day events.

Largest daily percentage losses

Source: Wikipedia