What Really Caused the Meltdown in 2018

We are coming off another strong week. Weakness on Thursday morning was met with buying to buoy the market positively. On Wednesday, Bespoke Investment Group put out a report saying that the S&P 500 is having a very rare comeback. To summarize:

  • After declining over 19% in the span of just three months, the S&P 500 has come roaring back and is now on pace for a 10% gain in just 10 trading days.
  • Since World War II, there have only been 12 other declines of 15%+ within the span of three months that were followed immediately by a 10%+ gain in 10 trading days or less.
  • Going forward, equity returns were generally positive, and in half of these prior sharp bounces off a 15%+ decline, the S&P 500 never made a lower low within the next year.

Why I find this interesting is that it fits very nicely with what we have been saying here. The MAP ratio went oversold in October – "expect a bounce." A 7% rally succumbed to wicked selling, pushing us oversold again. "Expect a rally," we said. Now, after 11 trading days, the S&P 500 closed up 10.4%.

Info tech, energy, consumer discretionary and real estate were the week's big winners as of this writing. This makes sense, as they were heavily punished for so long. It also fits with the theme of small and mid-caps seeing notable buying. The Russell 2000 outperformed signifignatly last week, as did the S&P Mid Cap 400 and Small Cap 600. Either way, it's both refreshing and eerie to see this much green.

Performance of major indexes

At Mapsignals, we have been looking into "trips." When we run our models, we scan 5,500 stocks per day. We find that there's only about 1,400 of those that can absorb institutional-sized orders without major impact on price. Out of these, the model gets "tripped" by stocks that trade on above average volume and volatility. The past five-plus years show us that an average of 500 stocks per day is the norm. (This means that roughly 35% of institutionally tradable stocks trade on larger-than-average volume.)

Don't confuse trips with the actual buy and sell signals that we generate. Trips just mean that a stock is trading unusually. In order to get a buy or sell signal, the stock also has to break above or below a recent technical high or low. So, what are trips telling us?

Below is a 29-year chart of the S&P 500 with days of trips, or unusually traded stocks and exchange-traded funds (ETFs), that were twice the daily average or more noted in red. You will typically notice that extreme selling days yield a lot of trips. This is logical, but as noted in the past several weeks, extreme lows tend to also coincide with big ETF signal days.

29-year chart of the S&P 500 with days of trips noted in red

The next chart shows the S&P 500 vs. unusual activity (UI) signals made by ETFs.

Chart showing unusual activity (UI) signals made by the S&P 500 and ETFs

This starts to fall into place. We have been postulating that ETFs are the tail that wags the dog. That is, ETFs through massive asset gathering and allocation become the directors of market direction – especially under periods of uncertainty and heavy pressure. This lends even more credence to the thought that the sell-off in October through December began with uncertainty over rates, trade and a global growth slowdown. This took buying pressure out, which paved the way for high-frequency trading (HFT) to profit off of thin liquidity and high volatility. The pressure of that condition led to ETF model management reaching sell triggers. Liquidations of ETFs caused a massive dislocation in the market.

An individual stock can be present in many ETFs. For example, according to, Facebook, Inc. (FB) is present in 138 ETFs, totaling about 200 million shares. A redemption of hundreds of ETFs on the same day, as seen by the orange spikes above, coinciding with heavy selling, amplifies volatility in a big way, in our opinion. Add to this the phenomenon that, when markets are down, ETF spreads tend to blow out, which also affects stock bid/offer spreads.

It's clear to us that ETF passive management gobbling up retail assets for decades has reached a tipping point. The ETFs move stocks, not vice-versa. A larger study is almost concluded that will go into much greater detail, but I'll say it clearly here: we believe that 2018's horrendous finish was caused by fear vaporizing buying, and as soon as it got too uncomfortable for retail managers, ETFs caused a monstrous cascade of selling.

So, when financial advisors (FAs) who spent a decade-and-a-half gathering assets and plopping them into passive management vehicles (ETFs) have their model managers say to hit the sell button, the FAs all rush for the exits on the same day. This is what happened this past fall. We feel that ETFs were the offenders. As George Herbert said, "The offender never pardons."

As of now, for Mapsignals, our ratio is increasing and currently sits at 34.3%. We are seeing more buys than sells in stocks for a few days now. In fact, the past six days have averaged approximately 85% buying. (This means our data says that 85% of our buy and sell signals in stocks are likely buy tickets.) Homebuilders, health care and info tech are starting to get bought.

The ratio has a low value because it is a five-week moving average and the prior four weeks were in favor of selling. As noted in last week's study, when the ratio pops back above 50% after being below 50% (sellers in control) for 40 days or more, forward returns should be strong from one to twelve months out. We have two weeks down so far of positive action for the market.

Small and mid-caps lead the rebound, and the market is being reliquified. Pension funds, mutual funds and assorted other institutional managers are deploying capital and bringing liquidity back into the market – something we noted should happen (in prior weeks).

The Bottom Line

We continue to be bullish on U.S. equities. Our belief is that trade will be resolved, and the Fed is now being apologetic in Fed speak and walking back its language. Fourth quarter earnings are upon us, and we believe that we are in for another strong earnings season. We look for a more selective phase of the bull market for 2019.