Now, let's examine possible future "market drops"
- there are multiple, identifiable ways that stock markets "go down"
- our reaction to each "drop" should be different
Since the stock market basically goes up most of the time, quant models are mostly looking for corrections and market crashes (market drops) that happen in up markets.
- below are some definitions of typical market drops (and how quant models should react to each)...
1) Normal "Dips"
In long-term up-markets (like now)
- stock markets move in cycles (like a sine wave)
- this means that an up market will experience normal ups-and-downs along the way
- this is what has happened in the last 11 months
- along the way, the MIPS models have determined that these drops are normal, not a new serious drop of 20-50%
- many commercial models that have tried to capitalize on these small dips have gotten whipsawed (big losses, up and down)
Nothing special causes dips this, as it is "the norm" of movements for bid-and-ask markets
The investment community has named a market drop of over 10%-15% (but not over 20%) a "Correction" in the market
- most corrections happen in normal markets as the result of some "bad-news events", not from bad economic business fundamentals
- a good example of this was the correction between 4Q'19 thru 1Q'20 that resulted from bad news regarding the Brexit
- during this time, the market fell in almost a straight line from the beginning-to-end of 4Q'19 and fully recovered in a straight line by the end of 1Q'20
- the pattern for this type of correction would be called a "V-Bottom"
In addition, many corrections result from extremely overbought markets (where investors have pushed up stock prices way higher than they are worth)
3) Market Crashes
Market crashes are when market indices (like the DOW, S&P500, Nasdaq 100, Russell 2000) drop over 50% in a one or two year period
- in the market crash of the 2000 recession, the Nasdaq index dropped over 60% and took over 16 years to recover
- in the market crash of the 2008 financial crisis, the SP500 dropped 55% and recovered within the next two years
Normally, Market crashes result from a very poor economy (like a recession or depression).
- by poor economy, we mean low consumer spending, lower business revenues, lower profits, higher debt, high borrowing rates, etc
- this is like being in a slow moving, bad news environment with a relative long-time recovery
- in the market crash from the depression in 1929, the market fell 90% in 2 years and took over 20+ years to recover
Under no conditions (except using Quantitative models that hedge by effective shorting), should you be fully invested in a market crash.
4) MIPS in the 2008 crash:
Below is the actual performance of MIPS in the crash of 2008
Red dots are trade dates 4Q'07-1Q'09 => MIPS3 +155% SPY (buy/hold) -54%