Posted by on September 4, 2017 4:58 pm
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Categories: capitalism Central Banks Deutsche Bank Economy Finance Futures contract Investment Market Crash Market trend money north korea Recession recovery S&P 500 Short Interest US Administration

As Deutsche Bank warns in a note over the weekend, the S&P 500 is “long overdue for a pullback” for one simple reason: the BTFDers (and central banks) have overextended the current rally in the S&P 500 to the point where it is now one for the history books. Traditionally, 3-5% selloffs in the S&P 500 have occurred on average every 2-3 months. By comparison, the current rally has now gone 10 months without even a moest a 3% correction, “making it the 3rd longest since World War II without one.” In fact, as the chart below shows, the only times an equity rally ran longer without a 3%+ selloff was in 1993 (11 months) and 1995 (1 year).

Not surprisingly, so far in 2017 virtually all of the (quite modest) selloffs that occurred, were associated with US political and geopolitical concerns and events—around the French election; the Comey dismissal; tensions with North Korea; US administration turnover and terrorist attacks.

However, as a result of the nearly $2 trillion injected by central banks YTD, all of these market “shocks” have so far proved to be fleeting and an invitation for the BTFDers to jump right in, and fill the gap within days if not hours.

So assuming the market is indeed poised for a correction, will that be the beginning of something more serious?

According to Deutsche Bank, the answer is no, because the bank’s chief equity strategist, Binky Chadha expecs the economic and market context to dominate. On the economic front, Binky sees further upside to global growth, with PMIs having further to recoup pre dollar and oil shock levels, a strengthening in the US labour markets and capex, while the he also expects earnings growth to sustain in the double digits. On the market front, he sees the demand-supply picture for US equities becoming more supportive with inflows on a turn up in data surprises and higher rates as inflation picks up.

Chadha points out something else notable: aggregate short interest –  or the cumulative shorts across cash equities, ETFs and futures by asset managers and leveraged funds positioning in S&P 500 futures – is now back to the bottom of the post-2007 band. Furthermore, as DB adds, the rally in the S&P 500 since the election has been notably driven by positioning, with the aggregate shorts as a proportion of the S&P 500 market cap have been fluctuating within an elevated band of 1.8% to 2.8% since the start of the Great Recession in 2007, compared to an average of 1% earlier. Since the election, aggregate short interest has moved from slightly above the band to the bottom. This was driven initially by a large reduction in shorts in cash equities and ETFs but since by rising long positions in S&P 500 futures.

Assuming Deutsche is right, and the next geopolitical shock does not cause a market crash, here is what to expect in terms of market response going into, and out of a “typical” geopolitical events.

According to DB’s calculations, the typical S&P 500 trajectory around domestic political and geopolitical shocks since World War II has historically been of sharp, short-lived selloffs with relatively quick subsequent rebounds. Here is the average pathway:

  • Down a median -5.7%;
  • Then 3 weeks to find a bottom;
  • Another 3 to recover prior levels;
  • And significantly higher out 3 months (6.5%) and 12 months (13%).

Beyond this average behavior, it is clear that the economic context dominated. So for example the oil embargo of 1973, with clear negative economic impacts, saw the biggest selloff and slowest recovery. By contrast the Vietnam and two Gulf wars, the Kennedy assassination and Clinton impeachment proceedings occurred against the backdrop of economic recoveries and saw sharp short selloffs followed by long-lived rallies.

In other words, of the nearly 30 major domestic political and geopolitical shocks since World War, it took the market on average 31 days – or exactly one month – from onset until the “dip buying” rebound, brought the market back to where it was previously, filling the gap and continuing higher.

One final item worth noting: in recent years the “recovery” duration has collapsed, in some cases to hours not day, as algos rush from one sentiment extreme to the other, making recent market dips a “blink-and-you-missed-it” phenomenon. That said, rarely if ever before has the market had to gamble with the risk/return odds on a geopolitical shock that could metastasize into a global nuclear war. In which case, should a worst case scenario happen, do not expect a 16 day recover from trough to peak, no matter how many stimulative “broken windows” the mushroom clouds unleash.

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