The Next Two Weeks are on High Alert for Crash Risk

By Justice Clark Litle

The next two weeks have heightened “crash risk” for various reasons. While vigilance is always a good idea, it makes sense to be even more vigilant over the next 10 trading days or so.

“Hold on,” you might say, “Didn’t the market just crash?”

After all, the Dow Jones industrial average saw its biggest single-day decline since 1987 this week. Meanwhile European equities had their biggest down day ever in percentage terms, and the S&P 500 broke a record for the fastest pivot from all-time highs to bear market status.

It’s true the Dow’s decline on March 12 was one for the history books. And yet the real market crash — perhaps call it “the big one” — could still be ahead. For the next two weeks, the risks are highly elevated. There are multiple reasons for this:

  • Crashes are like earthquakes, with early tremors signaling a big one. 
  • Coronavirus worries are about to intensify.
  • The Federal Reserve could try something drastic next week — and fail to calm markets.
  • The treasury bond market is behaving in an ominous way. 

First, we know from history that market crashes are like earthquakes. Sometimes they come out of the blue, but more often than not, there is a series of smaller crashes. For some odd reason, when “the big one” hits, it is likely to be on a Monday.

In 1929, 1987, and 2008, there were violent, volatile moves and big price dislocations in the trading days leading up to the big event. At the same time, each of these happened on a Monday:

  • The “Black Monday” crash of 1929 was Oct. 28, 1929.
  • The “Black Monday” (same name) crash of 1987 was Oct. 19, 1987.
  • The 2008 crash was Monday, Sept. 29, 2008.

This pattern suggests looking at a calendar. Is it currently a Monday? If not, the coming Monday might be “the big one,” with the current day’s action just a prelude. We’ll be watching extra closely on March 16 and 23.

Markets are also crash-prone at this time — still — because coronavirus fears are escalating as headlines and government announcements get worse.

The great worry for the United States — and the worry is justified — is that the country is on track to replicate Italy’s experience with an overwhelmed health care system.

As of mid-March 2020, Congress and the media are just beginning to grasp the seriousness of America’s test kit shortage, mask shortage, and ventilator shortage.

In order to avoid what happened to Italy, social distancing measures will likely ramp up further in the coming days, even as caseload numbers take off (through increased testing) and fatality numbers shoot up. The headlines generated by this process will be unsettling and could contribute to market unease.

A third issue is the Federal Reserve, which has tried and failed twice to calm the markets.

On March 3, the Fed announced a surprise rate cut of 50 basis points, a type of emergency move last seen in the 2008 global financial crisis. And then earlier this week, on March 12, the Fed announced a $1.5 trillion capital injection to help stabilize markets.

In both instances, the stock market ignored the Federal Reserve. Rather than going straight up like a rocket — the “normal” response to gigantic policy moves — stocks just kept falling on the days the Fed acted.

The Federal Reserve has its next official meeting next week, on March 17 and 18. Wall Street expects the Fed to act boldly once again, cutting the interest rate target from 0.75% all the way down to zero. The Fed might also announce an aggressive new policy measure, like the introduction of QE4.

Here is the thing, though: You can’t solve a consumer crisis with monetary policy, and that is what this is. If people are staying home because of the coronavirus, the Fed can’t make them go back out.

This creates a risk that, after its next meeting, the Fed will fail a third time, in terms of the market telegraphing a message of “who cares” or “still not enough.” If that happens, enough investors could be spooked out of stocks to cause a crash.

And finally, the U.S. treasury bond market is acting very strange. This hints at problems behind the scenes that could lead to a blow-up.

It’s normally the case that, when stocks go down in value, safe-haven treasury bonds rise in value.

This relationship powers the logic of the “60-40” stock-and-bond portfolio, banking on the assumption that, if equities aren’t doing well, the bonds will gain value as a kind of hedge.

There is also a strategy known as “risk parity,” used by some of the world’s largest and most sophisticated money managers, that essentially takes a 60-40 bond portfolio and leverages the bond piece.

Like the 60-40 portfolio, risk parity strategies depend on bond prices going up when stock prices go down. This correlation has been around so long most people assumed it was permanent.

And yet, over the course of the last week, the price of 30-year treasury bonds fell along with stocks. The historic 60-40 relationship stopped working: Stocks and bonds fell at the same time.

This is dangerous because hundreds of billions of dollars are deployed in risk parity strategies, and trillions of dollars’ worth of retail investors have something comparable to a 60-40 stock-and-bond portfolio mix.

In both of those cases, the bond side of the portfolio is supposed to behave like insurance. If it stops doing that, investors large and small could be forced to sell everything — stocks and bonds alike — in order to reduce risk while converting the portfolio to cash.

That kind of mass-scale selling, where some of it is fear-based and some of it is driven by investor redemptions, is the kind of thing that powers a market crash. There have also been enormous price declines in the corporate credit markets, suggesting severe stress. When things go haywire like this, the odds increase that some giant, heavily leveraged player blows up.

We can’t be certain what the future holds. Nobody has a crystal ball. And yet, when you look at this confluence of factors, it’s clear why the danger is elevated for at least the next two weeks.

And so, if “the big one” hits next Monday or the Monday after, financial historians might be adding “the crash of 2020” to the history books alongside 1929 and 1987.