The Stock Market’s Ability to Rebound from Geopolitical Shocks

By Jeffrey Hansen – CPM Investing, LLC

A slightly pessimistic tone has developed in the markets. The geopolitical risks involving potential clashes with North Korea and Venezuela seem to have influenced markets. We also have words of caution from well-known investors about near-term market declines. Jeff Gundlach, a well-respected bond manager, has said that those holding risky bonds should start heading for the exits; he mentioned high-yield bonds and emerging market bonds. Others have echoed his comments.

This is a good time for us to assess the stock market’s ability to rebound from geopolitical shocks, its maturity, and how this bull market might proceed from here.×1.jpgIn a letter to clients a few weeks ago, I recommended reducing the equity exposure of their portfolios to 80% from 100% by July 28. Our research indicated that the stock market was losing resilience, and a shift in allocation was appropriate at that time.

While our portfolios became more defensive, many of our indicators suggest that the market will be able to rebound from any near-term declines that may be caused by moderate shocks. The long-term trend of the stock market is still positive. Near-term vulnerability will be replaced by high resilience in a few weeks, and resilience imparted by the positive longer-term trend will be more apparent.

Of course, the magnitude of a geopolitical event is important ― a sizable nuclear conflict may overwhelm any inherent market resilience. Nonetheless, the market is still relatively resilient and should be able to recover quickly from market declines caused by current global tensions.

Regarding the cautious tone from well-known investors, we do not see the typical signs of the stock market reaching a peak and then experiencing protracted declines. Again, the longer-term positive trend in the DJIA is still intact.

What History Tells Us About Market Declines

Our research on the last 100 years of stock market price movements indicates that protracted market declines are typically foreshadowed by a weakening of our proprietary Macro Resilience Index. Weakening resilience suggests greater vulnerability, and then some catalyst occurs to initiate the protracted decline. The progression from resilience to vulnerability to decline typically takes place over a period of a few quarters, giving advanced notice to reduce exposure to the stock market. This is generally true for the prominent declines of 1929, the 1970s, 2000, and 2008.  We are not yet in that type of environment.

However, the sharp decline of 1987 stands out as unusual. This decline was not foreshadowed by a smooth reduction in our long-term resilience measure. If we are indeed coming to a major decline while our long-term trend measure is still positive, it would be generally similar to 1987. Let’s take a closer look at what led up to the sharp 20% decline in August and September of 1987, exactly 30 years ago.

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Our measure of the long-term trend (the Macro MRI) did shift to a vulnerable reading in November of 1986, almost a year prior to the decline, but it switched back to positive in May of 1987. And it made these changes after a long upward trend – almost 3 years after a decline in the Macro MRI and the stock market in late 1983 and early 1984. The Macro MRI had moved to a high level that placed at the upper extreme of the range it has traversed over market cycles since 1918.

Today, the Macro MRI is stable and steady. It can still move higher and still be within the normal range it traverses over a market cycle. It is moving higher in a recovery from the phantom bear market we experienced in 2015/6 ― just over a year ago.  In short, measures suggest this market is simply less mature and less extreme than the situation in 1987.