On Friday, the DOW fell 361 points and then yesterday the DOW gained 1,627 points. That is a sign that the market probably bottomed on March 23 and is beginning a climb back to new highs. It is a pattern that we have seen before. Let me give you the explanation of why I say this.
The easiest illustration is Black Monday, October 19, 1987, when the DOW plunged 508 points – 22.6% in one day. People remember Black Monday, but what might have been more important was April 20, 1987. When the markets fall like they did on Black Monday, or over several days in March 2020, almost all the buying is by market makers.
The right to make a market in some stocks on the New York Stock Exchange can sell for up to $ 4 million. That is just the right to make the market, like buying a license. The obligation of market makers is to make an orderly market in the stocks for which they have the right. If there are no sellers, the market maker will short the stock if there are no shares in their inventory. If there are no buyers the market maker is the buyer of last resort.
I use 1987 to illustrate what happened last Friday and Monday because Glass Steagall was in effect then. Glass Steagall was the act passed after the Great Depression that prohibited banks from owning brokerage houses.
When the market plunged on Black Monday, the buyers were the brokerage firms. Those firms did not have the capital to pay for the stock that they had purchased. They needed to borrow from the banks to make good on their purchases. The banks balked and were not going to grant the loans. Alan Greenspan had just been appointed Chairman of the Federal Reserve, however, and he called the banks and ordered them to give the brokerage firms the loans to cover their purchases.
Had Greenspan not done that and the banks refused to step up with loans, the financial system would have collapsed. The brokerages would repay the loans as they sold the shares in their inventories to buyers. The financial system held up.
So what does this have to do with last Friday and Monday?
When the markets were selling off in March, most of the buying was done by banks who now own the brokerage firms. They are the market makers. Unlike in 1987, the banks were able to go directly to the Federal Reserve and borrow money at zero percent interest. But that left them owning a lot of stock. In fact they owned multiple trading days of stock.
The typical plan, whether it be 1987, 2000, or 2020, is that the market makers will buy shares at the price they believe they can sell within a relatively short time at a slight profit or breakeven point.
My understanding from knowledgeable sources is that institutions saw the markets plunge and wanted to buy what they considered very cheap stocks. The problem is they had little cash and they could not sell their bonds because the bond market had frozen. In stepped the Federal Reserve, and then began to buy $ 700 billion of corporate bonds, municipal bonds, and other paper in the open market. That furnished the cash for the institutions to buy.
Now there were buyers and market makers as sellers.
Between March 24 and Thursday April 2, the market rallied some and then the market makers began selling. The selling reached the point where the market began to decline, and the market makers quit selling until the market gained again. Day by day, the market giggled up and down until Friday April 3. On April 3, the market opened and over the course of the day slid slowly down to finish off 361 points. The giggling was absent. It was a slow decline.
On Monday the markets surged. The DOW gained 7.7%. The S&P 500 gained 7%.
This pattern has a meaning: market makers are clearing off their inventory. On Friday, market makers were so close to having sold off all the shares they purchased during the March decline they let the last shares go at slightly lower and slightly lower and slightly lower prices.
By the end of Friday, the market makers were done. On Monday the buyers returned.
What all this means is that there is, in my opinion, a good chance March 23 was the bottom of the plunge. There could be very bad news that comes in the next week or month that sends the markets down, but it is less likely in my opinion. We may have seen the worst.
In addition, as first quarter earnings come out analysts will get their first real look and understanding of how the COVID-19 pandemic has actually impacted companies. They will probably revise down their estimates for the remainder of 2020 and for 2021. But as we get closer to mid-2020, the focus will shift to earnings in 2021.
Last Friday and Monday were, from my historical perspective, important days signaling that the markets are on the mend. In 1987, the markets recovered 1/3 of the loss in 90 days and the full recovery in 9.9 months.