The tail has been bitten, but the signal hasn't reached the control center yet.
Whiplash for the Brontosaurus
When markets are their most bizarre, as they have been in the last 24 hours, I find myself embracing the brontosaurus. That long-tailed dinosaur was the hero of an analogy drawn by Jeremy Grantham, the highly respected co-founder of fund management firm GMO in Boston, back in the summer of 2007. I have found it useful ever since. The brontosaurus symbolizes the stock market, and the key point is that giant dinosaurs were exceptionally slow on the uptake.
This is what Grantham wrote:
In the fixed income markets the disease – best characterized as the questioning of previously blind faith – slowly spreads: a little widening of the junk bond spread here and a little tightening of private equity credit there. But as yet the equity market seems totally unaffected with volatile and risky stocks still making the running. Although the brontosaurus has been bitten on the tail, the message has not yet reached its tiny brain, but is proceeding up the long backbone, one vertebra at a time.
To be clear, Grantham was talking at a point when much of Wall Street had accepted that we were already in a financial crisis. Here is how my Bloomberg Opinion colleague Justin Fox , then of Time, wrote up Grantham’s comments in July 2007:
Again and again in these past few months, financial markets have appeared to be on the verge of something very scary. It happened first and most jarringly in February, when subprime-mortgage woes made headlines in the U.S. and a market crashlet in Shanghai sent global stocks into a swoon. Lately the scares have been smaller but more frequent: a sharp rise in interest rates in May, runs on a couple of hedge funds in June, a sudden drop in demand for risky mortgage and corporate debt in July….
Then markets calmed, the Dow cracked 14,000, and the world got back to business. Don't count on that happening forever--today's jitters do probably presage something worse. "Rather like a brontosaurus that has been bitten on the tail and most of the body hasn't noticed it yet, the signal is working its way up the vertebrae," says Jeremy Grantham.
The similarities with the market moves of the last few days are obvious. A few weeks ago, the brontosaurus’s brain at last got wind of the rise in bond yields, and began to grasp that valuations may no longer be sustainable. Cue a huge rotation toward stocks that would benefit from higher yields and reflation.
Then on Tuesday came the moment when the brontosaurus twisted its giant neck to see what was happening, and gave itself and everyone riding on its back a terrible case of whiplash.
Tuesday was an epic reversal, interrupting a historic rotation. Suddenly, out of nowhere, the Nasdaq Composite index gained more than 4%, and Tesla Inc. somehow rose 19.6%. In one day. That raised its market cap by $107 billion — which is exactly equal to the entire market value of BlackRock Inc., the world’s biggest money manager.
But the bottom line remains that the rotation is intact. Tuesday’s dramatic rebound was the kind of dumb and reactive move that you might expect from a brontosaurus; it doesn’t tell us which direction the market is going in.
One way to show that the rotation is unbroken for now is to look at the relative performance of value and momentum stocks, as measured by Bloomberg. Value did far worse than momentum on Tuesday — but the trend remains clear:
Meanwhile, the key measures of the bond market did not move much at all. The 10-year yield was crimped back, as was the five-year inflation breakeven, but both were minor moves that didn’t shift the underlying trend. Note, incidentally, that although the explosive rise in yields over the last few months has been the catalyst for the current frenzied equity activity, the biggest trading days for the stock market have been relatively quiet for bonds. Stocks have been late to grasp what is going on.
It’s also important to recognize that what is afoot is a rotation, and not a selloff. Despite the remarkable trading action, the effect on the broader benchmark indexes continues to be unremarkable. The equal-weighted version of the S&P 500, in which each stock accounts for 0.2% of the index irrespective of its size, finished Tuesday within a whisker of its all-time high. The “average stock,” if there is such a thing, is doing fine. And the decline in broad all-world indexes, including all developed and emerging markets, is nothing to write home about. The last two days of frenetic drama in U.S. markets barely show up:
Does Tuesday’s upheaval have any predictive value? Not really. Big rebounds generally only come when a market has fallen a long way and become oversold. Critically, they don’t generally signal that the bottom has been reached. As evidence, note that the single best day for the S&P 500 since the war was Oct. 13, 2008, when it rebounded by more than 11% after a fall of more than 20% the previous week. There was no particular news that day, and the bottom wouldn’t come until March of the following year. The other biggest gains for the S&P on the chart below all fit this pattern — they were dramatic interruptions to downward slides, as stocks became temporarily oversold. None signaled an end to the selloff. So there is no particular reason to assume that the decline for the Nasdaq and tech stocks is over:
A look at the past history of big divergences between the tech-heavy Nasdaq and the Dow Industrials is also instructive. Bespoke Investment Group charted all the days when the Nasdaq dropped more than 2% while the Dow was up for the day. There aren’t many of them, and all the previous ones came as the Nasdaq bubble was in the process of bursting 21 years ago. Such big and disparate moves, at the risk of stating the obvious, are a sign that something isn’t right:
It’s also important not to be too excited by huge percentages following a big decline. The following chart, also from Bespoke Investment Group, charts daily changes for the ARK Innovation exchange-traded fund, flagship for the currently very famous tech investor Cathie Wood, and shows that Tuesday was its best single day ever, returning more than 10%. The lower chart shows that this has still had little impact on the direction of the share price.
What can we predict for the future? Much depends on bond yields. So far, their moves have been slow enough to avoid bringing the brontosaurus to its knees. A sharp rise in bond yields from here — and this is something that has been feared since the global financial crisis, without ever coming to pass — could do a lot of damage. But the key will be in the bond market.
For now, I’d like to return to Grantham, writing in July 2007. He was frighteningly prescient, predicting that the stock market would last out the year (it peaked in October), and that the risks of all-out failure wouldn’t become high until October of the following year, which was exactly when the selloff turned into a rout. The following passage, also from the brontosaurus memo, is uncomfortably similar to what has been happening in the last few weeks:
In just 3 or 4 weeks in June the 10-year bond rate jumped by 60 basis points. This was not, we are assured on all sides, caused by inflation – although a June survey of investment managers did indeed show a sharp jump where 45% of them were concerned about inflation. No, it was caused by an increase in “growth,” whatever that means. What was impressive and surprising, though, was the similar rate increase for 10-year TIPS, which moved rapidly from 2.1% to 2.8%. So we can understand some odd theories coming out. But rising TIPS means that the broad cost of capital or the risk-free rate has risen, and by a lot! This of course should cause an immediate and severe sell-off in all asset class prices as well, for in theory they are affected by changes in the real discount rate more reliably than anything else. But, in practice they did not fall, for as always the real world is merely an inconvenient special case. Indeed, emerging market equities surged in precisely the same 4-week period, gaining almost 10% against other equities. To rub it in, volatile stocks in most markets, but particularly in the U.S., beat the pants off safe stocks, thumbing their noses at any suggestion that they were impressed by the increased appreciation of risk by their fixed income colleagues. We wonder if this will come to seem like the behavior of headless chickens: the equity guys are often the last to know they’re dead. But it has always seemed likely that this would be a global equity market that would die hard.
After all this excitement in the stock market, I'd like to suggest some appropriate reading. This month's Bloomberg book club selection is Reminiscences of a Stock Operator by Edwin Lefevre, the investment classic that tells the story of the adventures of the speculator Jesse Livermore in the first two decades of the last century. There is nothing new under the sun; his exploits, written with clear explanations of what he was doing and much psychological insight, read like the unusually honest memoir of a contemporary hedge fund manager. It's genuinely fun to read, like a novel.
There is one big change of plan. We were going to be holding the live blog to discuss the book next Wednesday, to help fill the quiet hours before the Federal Open Market Committee meeting in the afternoon. Unfortunately, there is now a direct clash with a congressional hearing on the goings-on around GameStop Corp. (currently rebounding and up more than 1,200% for the year) which is very much the kind of adventure in which Jesse Livermore involved himself, so we will postpone for a week. We will hold this conversation instead on March 24, starting at 11 p.m. New York time (4 a.m. London time). Discussing it with me on the terminal will be Larry Tabb, long a guru of market structure and these days a Bloomberg colleague, Jamie Catherwood of O'Shaughnessy Asset Management and best known as the “financial history” guy who runs the Investor Amnesia blog, which I enthusiastically recommend; and my brilliant colleague from the Bloomberg markets reporting team, Kriti Gupta.
As for arrangements, if you want to follow the discussion live, you need access to the terminal. You can still ask questions in advance by emailing them to the book club email: firstname.lastname@example.org. The full transcript will be published on the web in the New York afternoon. Yes, if you want to follow the conversation live and in real time you need a terminal; but everyone has the ability to participate by asking questions, and everyone has access to the full conversation. Please get reading (the book can be picked up very cheaply online), and send in any comments and questions. I will try to highlight responses in Points of Return over the next two weeks.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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John Authers at email@example.com