Thursday, December 20, 2018

This is fine.

Title reference.

We're out of the AR process volatility (estimated since 2010, blue region), but not yet out of the approximately 70-year 90% volatility (January 1, 1950-December 31, 2016, red region) of the S&P 500 estimated using the dynamic information equilibrium model (DIEM). In fact, the S&P 500 has been this low before (relative to the the DIEM) — in February 2016. That was towards the end of the period of decline in the months after the first Fed rate increase since the 2008 recession. The index subsequently recovered. Prior to that, we skimmed the lower edge of the 90% confidence interval in 2011 as Europe was going into a double dip recession. We can see both of these in the a longer view:

But also looking at the longer run, most of these dips are just that — dips associated with a recession. There are only two major collapses that warrant adding a shock to the model (dot-com bust and 2008). Of course, it's possible to model the longer negative shock in the 70s as a series of smaller shocks, but none are close to the scale of 2001 and 2008.

Given most of the history of the market, we should expect the current dip — should it extend significantly below the confidence limit — to be just that: a dip likely associated with a recession or at least (seemingly unnecessary) Fed rate hikes. However, given the recent history of the market, we might expect a larger collapse as part of what I've called the "asset bubble era". This period, roughly since the 90s, is period after the demographic shock of the 60s and 70s has faded, inflation has subsided, and e.g. labor force participation ceased rising rapidly.

Note that as part of the asset bubble era, the asset bubble doesn't have to be reflected as a bubble in the market itself. The dot-com bubble was, but the "housing bubble" was accompanied by basically equilibrium growth in the S&P 500 index. However as part of the asset bubble era it might be accompanied by a new shock. Of course, it's quite early so estimates of the shock parameters are going to be wildly uncertain. I included several counterfactuals (dashed blue) with different constraints in this graph:

Two of the paths constrain the amplitude of the shock to be the median (absolute value) amplitude of all the previous shocks. One of those leaves the shock duration and timing to be fit to data, the other just leaves the duration. The timing was constrained to be the value indicated by the timing estimated from yield curve inversion. The third (and smallest) fits all three parameters. This is probably showing the undershooting and overshooting that is a drawback of fitting logistic functions to partial shocks.

I also included my joke path ("lol capitalizm iz doomd") I showed on Twitter the other day where the S&P 500 collapses to zero. I'd say that is unlikely (it is, however, the result of doing the fit with just a fixed shock timing).

Have we entered a new era since the 1990s where recessions coincide with major collapses in the stock market? Or will we return to the era before the 1990s where markets fall during recessions, but rebound quickly? My hunch is the former and I'm not looking forward to the economy in 2019.


Update 21 December 2018

We've pierced the toast the 90% confidence interval (updated counterfactuals):


  1. I'm pretty sure that prior to 1949, declines of 40%, 50%, and then the big one in 1929-1932 of something like 80%, were more the norm in stock markets than the relatively smaller declines in the 50s and 60s. It's possible the period from 1949-1994 was the exception – where the market had a lot of runway to increase equity valuations without them ever becoming too extreme on the high side – with the period since the 90s just a return to normal. Even then, you mention that an interpretation of the declines in the 70s might depend on how many shocks you model, with the ~45% decline in 1973-74 apparently lurking in what appears to be a smoother shock through the whole decade. Also, in the wikipedia article on the "1973-74 stock market crash," I learned that the markets in the UK declined by more than 70% in the same period! That's apart from a roughly contemporaneous decline of 85% in Hong Kong's Hang Seng in 1973, the more than 60% decline in Japan in the early 90s, and I'm sure many others that could be enumerated. Not exactly sure what you're arguing for, though, so not perfectly clear in my mind what I'm arguing against except to say that this sort of volatility in stock prices seems fairly normal and well within what we've experienced in the past and what I fully expect we will continue to experience in the future. But, yes, in the event of a recession, we will get trough earnings, and with trough earnings we will get trough valuations, and the S&P will go much lower. If we don't get a recession, earnings won't fall that far and the S&P will recover in relatively short order, probably within the next year. Guess I'll be checking in on your JOLTS and unemployment rate updates in the months to come to see which outcome we get. Thanks for keeping the analyses coming!

    1. Yes, that was part of the point I was trying to make: previous declines of this magnitude have happened with quick recoveries (in the data before the 90s). However, in the most recent data, deviations of this magnitude are associated with asset bubble collapses (dot-com, housing). If we just look at the market indices, we have no idea which we'll get. However, other data seems to suggest the period from 1950-1990 was "different" (e.g. major increases in labor force participation and resulting high average level of growth) -- per the links in the post above ("asset bubble era" since the 90s). It's purely speculative on my part.

      (I'd also note that the major declines before 1949 happened when labor force participation wasn't rising rapidly, so that might be the analogous scenario to today, not the relatively mild crashes of the 60s, 70s and 80s.)

  2. Love this, Jason! Looks like S&P has to fall below 2200 or so to be certain of a change in regime? If it does crash, looks like ~1500 will be a good buying opportunity. If things continue as they have, your gutsy recession call from last year may well end up being prescient.

    1. Thanks Todd. I wouldn't use any of this information to make any trades as I might well be a crackpot :)

      Also, the call was only from earlier this year (June, though it does seem like forever ago):


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