Thursday, December 31, 2020

"The End of Free Markets and The New Alchemy"

 From Price Action Lab:

After two back-to-back massive bear markets in the 2000s with losses in excess of 50%, the central bank finally stepped in and has since provided virtually unlimited support to equities in the form of quantitative easing and verbal interventions. That was the end of free markets and the beginning of a new age of alchemy.

In this article, we define a bear market as the usual drop in S&P 500 in excess of 20%. From 1960 to 1980, there were five such bear markets as shown in the chart below.

Then, in 2000s, there were two back-to-back bear markets due to dot-com bust and the financial crisis. Why did the central bank intervene after the financial crisis in support of the markets? There are possibly many reasons but in my opinion the main two are the following:

  1. More people nowadays depend on equity portfolio returns for their retirement than in the 80s.
  2. The market dynamics favored a further collapse.

We will concentrate on the second reason in this article. From the above chart, it may be seen that from about 1965 to around the late 80s, the 1-lag, 252-day autocorrelation of daily S&P 500 returns was high. This means that during those times returns exhibited momentum. This further means that positive daily returns had higher probability of being followed by positive daily returns. After 2000, returns became mean-reverting. This means that positive daily returns have higher probability of being followed by negative daily returns. So, why is this important?

To start with, the causes of this fundamental regime shift cannot be identified with high certainty. The shift probably occurred due to a combination of overvaluations, introduction of algorithmic trading and crowded trades in momentum. But the regime shift is a fact and this is all that counts.

In fact, from high positive autocorrelation the dynamic changed recently to extreme negative autocorrelation as shown in above chart. What does this mean?

In a nutshell, it means that after the market drops there is a reversal to the upside. Traders have called this phenomenon “buy the dips”. But who are compelled to buy the dips when it is obvious from forums that the majority of traders are bears and like the short side? The answer is, investors and probably companies buying back their shares. And why do they buy the dips? Because they are convinced the central banks will continue to support markets.

The chart below shows the percentage of down days in a 252-day rolling period that are followed by up days....