What Caused The S&P's Sudden Market Drop?

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Posted: Jun 29, 2020 1:04 PM
What Caused The S&P's Sudden Market Drop?

Source: AP Photo/Seth Wenig, File

As expected, answers to the questions we asked last week were forthcoming, allowing us to eliminate one of the two primary hypotheses we raised for what caused the S&P 500 (Index: SPX) to suddenly drop 5.9% on 11 June 2020.

The first hypothesis was that S&P 500 shifted their time horizon from 2020-Q4 to 2020-Q3, without any change in expectations for how expansionary the Fed's monetary policies would be, which is consistent with the first version of the alternative futures chart for 2020-Q2:

To see the chart, click here.

For this hypothesis to hold, we would have needed to see the trajectory of the S&P 500 track along with the expectations associated with investors focusing their forward-looking focus on 2020-Q3. We also indicated what we might expect to see if this hypothesis failed:

... if the shift that occurred on 11 June 2020 was the result of a change in expectations for the Fed's monetary policies, where the amplification factor in the dividend futures-based model suddenly changed to become less negative than it has been, we will see the trajectory of the S&P 500 start to consistently underrun the levels projected by the model as shown on the alternative futures chart above, which currently assumes no change in the amplification factor since 12 April 2020.

And that's indeed what happened, which allows us to reject this first hypothesis.

In the remaining hypothesis, we assume investors have incorporated the new expectation the Fed's monetary policies will be less expansionary going forward than they had previously anticipated, which we're showing in the change of the value of the dividend futures-based model's amplification factor (m) from -1 to 0:

To see the chart, click here.

There's a second variation of this hypothesis that assumes there was also a Lévy Flight event with investors shifting their attention inward from 2020-Q4 toward 2020-Q3, but we're unlikely to ever untangle that possibility with the limited data we have available.

That's because both these variations are consistent with what we observed in the last week, up until 24 June 2020. That date coincides with when we think another adjustment occurred to further rein in expectations for how expansionary the Fed's monetary policies will be going forward, which we see as a change in the amplification factor in the dividend futures-based model. We think the new value has risen to now fall somewhere between 1 and 1.5.

In the next version of the alternative futures chart, we show the amplification factor changing from 0 to 1 on 24 June 2020, where we assume investors have sustained their focus on 2020-Q4 since 4 May 2020.

To see the chart, click here.

Let's present one more new scenario. Here, let's show the amplification factor changing from 0 to 1.5 on 24 June 2020, but now, we'll assume that investors shifted their forward-looking time horizon from 2020-Q4 to 2020-Q3 on Friday, 26 June 2020.

To see the chart, click here.