A One in Five Hundred Million Event

A “six sigma” event.

That is what happened in the stock market a week ago, on Thursday, July 11.

What does that mean?

In statistics, a "sigma" represents a "standard deviation.” The "standard deviation" measures variability around the average of a data set.

A one-standard-deviation event is likely about 68% of the time.

To explain that in plain terms, if you have a low-volatility stock, it might have a daily standard deviation of 1.5%. That means that the majority of the time (68%), it would have an up or down move of no more than 1.5%.

If it has a more significant move, it is a higher standard deviation and less likely.

A two-standard deviation move covers 95% of possible moves, which means it will only happen about 5% of the time. A three-standard deviation move covers 99.7% of possible moves or happens only 0.3% of the time.

A six standard deviation move?

That has a 0.000000197% probability of occurrence. If you want to know the math, that is a one-in-FIVE-HUNDRED-MILLION chance.

Let’s just say that is rare!

What was the event?

Here is a post from the awesome strategist Charlie Bilello of This Week in Charts…

The event was the one-day outperformance of small-capitalization stocks (as measured by the Russell 2000) versus large-capitalization stocks (as measured by the S&P 500).

As you likely know, last Thursday, the big capitalization technology stocks sold off by several percentage points while seemingly every other stock was up by the same amount.

Usually, when we see extremely rare events, they often point to potential high-probability future outcomes.

Does this one?

We are not so sure.

As Charlie's post points out, the most significant move ever (much larger than this one) was back right after Lehman Brothers went bankrupt. It happened on October 10, 2008, and Lehman Brothers went bankrupt on September 15.

We were actively managing our hedge fund 360 Global Capital at the time, and a lot of stuff was going haywire. It is not surprising that we would see a statistically super unlikely event happen at that time.

We are sure we are NOT dealing with a Lehman Brothers-type situation right now.

The chart shows, though, that the performance spread between these indexes has grown recently.

We have seen a 3.6% and 2.7% move in the last year. Going back to the COVID period, we saw four moves greater than 2.5% in the year following the COVID bottom.

After the Lehman event, the stock market traded much lower until it bottomed out in March 2009. After these other moves, the stock market moved higher, and then lower post-COVID, and most recently just higher.

Is this move telling us something bad is about to happen?

We don’t think so. At least not yet.

It appears that these kinds of moves are becoming more common.

This directly reflects the growth in the stature of the most significant large capitalization stocks.

The S&P 500 is a capitalization-weighted stock index, so just a few stocks, like the "Magnificent Seven," can impact the index.

On Thursday last week, the S&P 500 was -0.87%, but the equal-weighted S&P 500 was +1.16%.

With the Russell 2000 up +3.6%, we certainly don’t take this as a BAD sign.

We have previously spoken about our "crowded raft" theory

and how the stock market (or a stock) can be like a raft going down a river. One side of the raft might be sunny and warm, while the other is cold and wet.

More folks might move to the sunny side as the raft continues down the river.

Then, when the raft inevitably hits even a small rapid, it can move violently because everyone moving has left it unbalanced.

It doesn’t mean the raft is going to sink! It just means that folks need to readjust.

We think that with the massive outperformance of the largest capitalization stocks in the last year, investors have been piling into that "sunny" side of the raft.

Moving back to the other side will not sink it. Instead, it will likely give it even more stability.

While we usually can read something into super low-probability events, we think that, in this particular case, it might not be telling us very much at all!

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