Making Sense of Today’s Market Rout

Ouch. We haven't seen a drubbing like this since March 16th, when the market sank 12% on its way to a 34% decline from the peak on February 19th to the trough on March 23rd. That 12% drop on March 16th was the second-worst day in 70 years, surpassed only by the 20% free fall on October 19, 1987.

Today's 6% drop was the 20th worst out of 17,725 trading days since 1950. How do we make sense of it?

Popular explanations from the financial media

• There was an uptick in Covid cases in some states.
• Fed Chair Powell warned about a slower economic recovery.
• The market was priced for perfection.
• Investor sentiment had become too bullish.
• Volatility had become too quiet.
• Investors had become complacent.
• Valuations are too high.
• The market was overdue for a correction.
• Some of the big tech leaders were starting to sputter.
• The rate on the 10 year Treasury Bond was starting to tick higher.
• The fantastic employment report had some warts on it.

All of the above are true, or at least have a ring of truth to them. Taken together, they make a lot of sense, but they leave me unsatisfied. Most of them were already known, to some extent, by investors as they drove the market higher and higher until Tuesday. That's when the tide turned.

So, what is the explanation for today's historic decline that will satisfy me? That's next.

Over-reliance on the market's ability to see the future

The market has a decent record of looking past bad news and moving higher in anticipation of good news. But in this case I think the market jumped the gun. The chasm we are facing with the economy, the course of the pandemic, and the recovery of corporate revenue and earnings is far deeper and wider than many investors assumed it would be. 

We'll get past this chasm eventually, and the market will probably be the first to arrive, but not until it gives back a sizable portion of its gains. There are just too many risks and too many unknowns for the market to continue on its recent upward path.   

Probabilities for what comes next

I do a lot of work with probabilities. Here are a few observations I've made, based on today's decline and the historical record of what has happened after similar events. There is an...

• 81% chance tomorrow will be an up day.
• 88% chance the market will be 10% lower than where it closed today, sometime in the next 3 months.
• 74% chance it will be 15% lower within the next 6 months.
• 34% chance it will be 15% higher than today at the end of the next 12 months.

As Benjamin Graham said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Since the recent bottom on March 23rd, investors have been voting for a speedy recovery and a return to normal. Today's action marks the beginning of the weighing machine market.