Where to now? COVID-19 In light of past crises

In thirty years of charting financial markets, BBSP has witnessed quite a few dramatic events — the tech-bubble burst of 2000, the post-9/11 panic in the fall of 2001, and the 2008 subprime crisis first come to mind.

As the world is now facing the threat of COVID-19, and a price war is rocking the oil sector worldwide, once again panic has seized the markets. It can be interesting to leverage some lessons of the past and see what light can be shed on the current situation.

The where and the how

One of our chief beliefs, is that though any market crash is triggered by some actual, fundamental context, bouts of market panic and overreactions appear largely self-sustained. That is, they’ll depend more on the history of the market itself than on the evolution of information regarding the threat.

We’ve seen such dynamics at work time and time again. We believe they are partially predictable, all the more in the face of a perceived threat. BBSP has pioneered a vision of financial markets as chaotic systems, driven by semi-deterministic group behaviours, long before the resurgence of academic interest for such topics — starting in the 2000’s — would offer a scientific vindication of our empirical beliefs.

For thirty years, we have been compiling a library of action-reaction patterns illustrating the fractal and chaotic aspects demonstrated by most financial markets: self-similarity, clustering, persistence of structures through randomness, and butterfly effect (being perfectly illustrated by the current market crisis)

We like to say that while fundamentals dictate where the price is going, the market’s internal dynamics dictate how it will get there. It's the how we focus on and try to illuminate; mapping the risks and establishing probable targets.

Panic implies predictability

Though uncertainty is, by definition, unpredictable, collective panic in the face of uncertainty is not.

In episodes of market panic, we can observe the herd behaviour of the more aggressive players all reassessing their bets in a short time, and closing off their positions in haste — with dramatic consequences upon prices. Whether those players are human or algorithmic it doesn’t make a difference, as traders and systems alike keep close attention to what others are doing, demonstrating aversion or impotence in the face of any situation out of the ordinary, the so-called “black swans”.

Such behaviours, fuelled by their own momentum, are structurally exaggerated: nearly always, they’ll miss the mark, overstate the menace, and, as soon as most actors realise it, trigger a contrarian move, with a violence matching the initial one.

This see-saw pattern, converging towards a more accurate pricing, is the building block of any market's history. It is also our main study material — through speed and rhythm analysis, pattern recognition, and comparative studies of correlated assets.

Never overlook the market context

Of course, it is not easy to assess the potential impact of a somewhat unprecedented event. The dramatic consequences, and above all human consequences, cannot be compared to a purely economic trauma such as the 2008 subprime crisis. In terms of market action, the differences are also, for now, conspicuous. The subprime crisis was the most dramatic phase of the 2000-2008 correction of the bull trend started in the 1980's. The end of a market cycle, which current crisis is not.

Whatever the menace, the market reactions of these last days have been fuelled as much by the latest developments of the pandemic, as by their own internal dynamics and history.

Looking at the S&P 500, it becomes clear that we’re coming down from unprecedented heights. 

The S&P registered an increase of +70% over the last four years. An increase which was nearly continuous, except for two noticeable alarm signals in 2018. Interestingly 2018 saw two marked corrections, the second twice the size of the first.

What’s in a drop?

Such is the context. It explains much of the excesses we’ve seen these last few days. The correction of 2018 was a first warning signal that sent a shock wave in the dynamics of markets, and we are now experiencing the full impact of that wave: all actors are abating the optimistic scenarios they’d been entertaining for years — and which appear, all of a sudden, as exuberance. This being said, the amplitude of their reassessment has to be measured in the light of their former optimism.

The risk of a mid-term market reversal was long-written in the price dynamics—and at BBSP, throughout 2019, we kept warning our clients about such an event.

(See our video explaining the risks of a big 2020 drop on S&P)

This was long before the COVID-19 pandemic, and I want to make it clear that I’m not claiming in any way that we “saw it looming” in the prices. What we saw was the mounting nervousness of operators near the end of a long bullish run—in other terms, the situation was ripe for a change of mood.

A question of scale and how we see it

A change has occurred—which brings me to the main point of this paper: though dramatic, the corrections of these last days, they still fit in our global scenario—a scenario motivated by price action internal dynamics, focused upon a correction within a long-term bullish structure. We believe that the long-term bullish trend started in 2009, in the wake of the subprime crisis, remains valid.

Within this context, a 40% correction, top-to-bottom, remains sensible, especially after a bout of exuberance. (As a comparison, the S&P lost half of its value from 2007 to 2009).

So, we’re not really facing the unknown here. Whatever their fundamental causes, the spectacular drops registered on world markets is the most dramatic phase of the correction initiated in 2018 and can be seen as the reflection of a former optimism — just as a stretched rubber bend liberates its pent-up energy, once released. We believe that such moves, consistent with our action-reaction patterns, were—and are still—predictable.

For violent as it is, the current market turmoil falls into the framework of the long term bullish trend started in 2009 . Our correction target on the S&P, within our bullish scenario, stands at 2,000/2,100—that’s the bottom we expect before resuming the bullish trend started in 2009. We’re almost there now!

Whatever the strategy, the idea that the drop would go on, but stop eventually around that level, is probably the most valuable pieces of information we could deliver to our clients in times like these.

As we published those levels a long time ago, some aggressive players, among our clients, may have shorted most of the drop. Most will be watching out for that bottom to start buying again.

 

Philippe Sadock, BBSP CEO.

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