🥊 Houdini's law

Hey hey, happy Monday.

Hope you all had a wonderful holiday weekend full of Reese’s peanut butter eggs (the best holiday candy, IMO).

I’m getting a lot of questions about if the worst of this stock market selloff is behind us. And while I can’t see the future (nobody can), I thought I’d talk to y’all about one rule of thumb you can use to judge fear and expectations.

A 5-minute read about a famous magician, and what his unfortunate demise can teach us about this particular market drop.

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Harry Houdini was one of the most prominent magicians and escapist artists in modern history.

He was also a man of considerable physical strength, often flaunting it during stunts and impromptu boxing matches.

Today, the story of his downfall is an important lesson for how market panics work.

In 1926 – during what would be his last tour as a magician – Houdini performed at the Princess Theatre in Montreal. Before the show, Houdini was met in his dressing room by a McGill University medical student named J. Gordon Whitehead, who asked if the prominent boxer-magician could actually sustain several huge blows to the abdomen without flinching. 

Then, out of nowhere, Whitehead sucker-punched Houdini in the stomach.

In a boxing match, you know a punch is coming. The best boxers know how to brace and maneuver to survive a bout of blows.

But this was not a boxing match, and Houdini was not ready for the punch.

A week later, Houdini was dead after a bout of acute appendicitis. His downfall wasn’t a torture cell escape gone wrong.

Instead, it was a simple, unexpected punch to the stomach.

One he could have absorbed if he had time to prepare.

Markets work the same way. No, a Wall Street broker isn’t about to burst into your living room like the Kool-Aid man and start swinging.

Often, the worst hits to your portfolio are the ones you don’t see coming—like sucker punches you didn’t have time to brace for.

I’d put Liberation Day and the ensuing fallout into the “sucker punch” bucket. Nobody expected 20%+ initial tariffs on our biggest trade partners (plus steep levies on uninhabited islands). No Wall Street expert projected 145% tariffs on China.

We were all sucker punched, and the selloff hurt like hell. The S&P 500 recorded a punishing 10.5% drop over two days, then proceeded to swing the most since COVID. The VIX – Wall Street’s “fear gauge” – spiked to 53, among the top 1% closes for the index in history. Extreme fear, expressed through a rush for options.

The stock market often crashes in a somewhat predictable rhythm. There’s an initial shock when people rush to sell stocks. They lower their expectations for the future. They stop dreaming of the potential of AI, mRNA, robotics and corporate efficiencies. They start talking about bunkers, tuna cans, and the end of the world – a time when you own nothing but what you can hold in your arms (ahem, gold). Fear grips the world.

When people are hopeful about the future, they’re willing to pay a higher price for stocks. When people are despondent, they don’t want to pay much more than what’s real. In this case, actual earnings.

This behavior can be seen in the S&P 500’s price-earnings (PE) ratio, a measure of where a stock or index is trading relative to the profits it’s expected to generate over the next year. Since February, the S&P 500’s PE has dropped from 22.4 to 18.1, an 18-month low.

We’ve lowered our expectations so far that any news short of disaster could feel like rain in the desert. 

It’s Houdini’s law of market sentiment. Surges in fear often signal the worst point of every selloff for this exact reason. Survive the initial shock, and any subsequent punch may not hurt as bad as we think.

Low expectations lead to relief rallies – the Wall Street phenomenon when people pile back into stocks because the news isn’t as bad as they thought it’d be. 

You can see this dynamic often play out in the VIX, the options-based fear index. When people are anxious about the future, they’re more likely to buy options (or contracts that give you the right to buy or sell stock at a certain price) to protect their portfolios.

Since 1990, almost half of the S&P 500’s 14 selloffs of 10% or more have ended within a week of the VIX’s highest close. Three ended on the day of the VIX’s highest close.

That’s why many Wall Street technicians – or experts who study lines on charts for hints about future direction – consistently preach to buy when the VIX is high.

Now, Houdini’s law has worked out well in the past.

But we may need to be careful about assuming too much this time around.

Many selloffs are quick shocks that don’t overlap with much economic damage. After all, a third of all 5%+ stock market drops since 1950 have lasted less than a month.

Recession-fueled market crashes, however, can be surprisingly destructive and notoriously tough to predict. They often include an initial stock, then a lengthy period when investors try to find the new center of gravity as earnings drop and unemployment rises.

Here’s a history of recession-backed market drops. That blue tier is how long it took the S&P 500 to drop 10% (the initial shock, more or less), and then how long the drop persisted after that.

Unfortunately, we may be in one of these recession-fueled market crashes right now. The consensus on Wall Street is that the lethal combination of dramatic tariffs, high interest rates and DOGE-related government spending cuts could put the brakes on economic growth.

Everybody seems to be watching economic data releases with gritted teeth, knowing the worst is likely yet to come. They may be right.

If that happens, we’ll all need to come to terms with a new reality. One with lower expectations and lower actual earnings. A punch we haven’t figured out how to dip, dodge or endure quite yet.

Think about fall 2008. Lehman Brothers filed for bankruptcy in September. The VIX shot up to 80 (one of its highest levels ever) a few weeks after, yet markets kept swinging as the Federal Reserve — our favorite interest-rate superheroes – and other institutions rushed to save the financial system.

The S&P 500 fell another 10% from November 20, 2008 (the day of the highest VIX close) to the market’s lowest point in March 2009. The punches kept coming, and we couldn’t roll with them.

I have to be honest with you, too. I’ve talked a lot about how the VIX isn’t the best representation of market fear because people aren’t using the specific options contracts the VIX tracks as much any more. I still believe this is (somewhat) true, and you can read my nerdy takedown of the VIX here.

Does the VIX’s efficacy matter here? Sure, a little.

Still, fear has clearly gripped the world. I could point to several metrics that sh0ow as much.

You may not be a pugnacious boxer or escape artist like Houdini, and Houdini’s law isn’t some random magic trick.

But at the very least, Houdini’s law is an argument to feel a tad bit more empowered here.

The initial shock looks to be over. The world is braced for a punch, and that’s exactly why your window of portfolio opportunity may be open.

If you have the right risk appetite and years ahead of you, of course.

Thanks for reading!

Callie

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