The Anatomy of a Sell Off: The Three Phases

Each sell off is different and there are no magic formulas to tell you when to ‘get back in’ or if it’s ‘too late to sell’, but there are some things to look for that help improve your odds.

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Typically, selloffs start because we get too optimistic and over positioned and some kind of catalyst makes us realize that maybe we have too much risk on. Sometime, it can be a catalyst that has hidden in plain sight for a while before we belatedly overreact, and sometime they truly come out of the blue. Obviously, the more extreme the optimism and positioning, the smaller the trigger (or set of triggers) it takes to unleash the selling.

Once the selling starts, it almost invariably shows up in the sectors and assets where the optimism was most vigorously expressed. In this case, that would be large cap tech. The selling can be sudden and severe. These names and sectors underperform (vol adjusted) pretty much everything else. This is what I call Phase I.

As the selling intensifies and the P&L pain starts to mount, the selling spreads into other areas and starts to slow in the sectors/names that got hit so hard in Phase I. The names and sectors that outperformed in Phase One effectively ‘catch down’ with the names that were at the center of the storm. In this case, you would start to see the S&P underperform the NASDAQ 100 (as we saw yesterday). This would be Phase II.

In Phase III, you typically see the hedges that you hastily slapped on late in Phase I stop working, even as the names/sectors/assets you held on to continue to get liquidated and go against you. Also, the indices start to get squeezy and jumpy, as more people finish their de-risking and their anxiety shifts to being caught out in or left out of a market rebound. But because in this phase there are still people who haven’t finished se risking, and because some of us get greedier/more confident on the short side (just like on the upside, success breeds overconfidence), investors and traders sell hard into those jumps and squeezes, making the intraday tape more two-way volatile.

We don’t always get the full three Phases in every selloff, and the elements above aren’t set in stone. But for the larger selloffs, and using a ‘weight of the evidence’ approach, this little roadmap can help identify where we are in the process and how hard we should be pushing our tactical bets. And, at a bare minimum, it’s a great check on our overconfidence.