Biggest Bull Trap in Stock Market History

30 בספט׳ 2022

We just experienced one of the biggest bull traps in stock market history.

A bull trap occurs when price reverses to the upside after a downtrend, such that market participants enter bullish or long positions believing that the downtrend has ended and a new bull run has begun. The trap occurs when price rapidly falls back down taking out the previous low and making new lows, thus continuing the downtrend.

Unfortunately, mostly everyone (except Wall Street market movers) loses money during traps. This is because both bulls and bears get stopped out of their trades as price whipsaws first to the upside, and then back to the downside. A bull trap is visualized on the chart as a candle with a long upper wick, which simply represents buying that was reversed by even more selling.

The above chart is a quarterly chart of the S&P 500. Each candle represents a quarter of a year (3-month period). The quarter that we just finished as of the market close today ended up printing the longest upper wick in the history of the S&P 500 on the quarterly timeframe. The upper wick measured -12.58%, which broke the previous record of -11.43% in 1974.

If we were to clone just the upper wick from the past quarter's candle, it would nearly contain the entire price movement of the S&P 500 in 2007, which puts into context just how significant of a price reversal we have seen this quarter. (The length was log-adjusted to account for inflation).







Here are some reasons why I believe the biggest bull trap just occurred:

Volatility of Volatility (VVIX)

The volatility of volatility index (VVIX) was suppressed too far to the downside and was primed to explode higher.

Back in July, I warned about this when I posted this chart showing that the stochastics of the VVIX were completely bottomed out and volatility of volatility could only go up from here:



When the VVIX explodes higher, traps can occur as volatility of volatility causes large price swings over a relatively short period of time. The VVIX became parabolic over the past 3 months as shown below. Since its bottom in July it has exploded 50% higher.





Monetary Easing

Another cause of this bull trap is monetary easing. Decades of central banks rushing to save falling markets with monetary easing have caused market participants to expect it.

Additionally, when the market began to fall in January 2022, market participants looked back to historical data to gauge when a bottom might occur, but the time period over which most market participants looked was characterized by a falling interest rate environment and monetary easing. Interest rates have not risen as fast as they are now rising in nearly a half-century, which is outside of the timeframe that most market participants considered, or even outside of the time period for which many traders have access to data. For example, the retail trading platform, Robinhood, only allows market participants to see data as far back as 5 years into the past. Without access to enough historical data, market participants simply had no way to know what was happening.

But for monetary easing stretching valuations to historic highs could the stock market even far by such an enormous degree without a sustained relief rally. Indeed, despite all of this selling, we have merely only come down to the peak before the Great Depression in terms of the Shiller PE Ratio.




Commentary
There's no doubt in my mind that we've been in a recession throughout 2022. Few market participants understand that you can have economic decline with record low unemployment. Ironically, it is record low unemployment that causes the economic decline!

When unemployment is too low, this creates a scarcity of labor. During a scarcity of labor, employers hire whoever is willing to work, often suboptimal candidates. These suboptimal candidates are often less productive because they are less skilled, less qualified, and generally need more training. These attributes are resource-intensive for employers and can reduce overall business productivity. In addition to expending more resources to onboard new employees, employers also pay existing employees more due to labor shortages (e.g. through overtime, bonuses, or other incentives to fill the labor shortages). Employees also begin to have stronger bargaining power during labor shortages and demand higher pay. Employers that do not give in and offer to pay employees more can lose their most experienced and productive workers to employers that pay more. This in turn forces highly experienced and productive workers to become less productive as they enter the learning phase of a new job.



When unemployment is too low, economic growth slows. Slowing economic growth coupled with rising inflation is the nemesis of central banks because it renders their main tool, monetary easing, useless. Knowing that inflation was coming central banks, tried to preempt inflation expectations by repeatedly claiming that inflation was transitory. Central banks knew that if the public begins to expect inflation, it could become a self-fulfilling prophecy and get much worse.

This extreme level of inflation was known and expected by the central banks well in advance. While claiming that inflation was transitory, the Fed was already scrambling to fight it behind the scenes. The Fed has actually been fighting inflation for a year and a half now.



As they purchased more and more securities at the front door to "support economy recovery", they were selling more and more securities at the back door (via overnight reverse repurchase agreements). Their behind-the-scenes tightening began in March 2021, a full year before it began publicly tightening.







I'll end with some food for thought.

We just had one of the worst first three quarters of a year in stock market history, despite the Federal Reserve only unwinding just 1.9% of all the stimulus it used to prop up the stock market.






Below is an inferred 322-year look back borrowing contextualized data from the Bank of England.



Imagine if inflation forces the central banks to unwind a lot more...