February 26, 2020

With the sharp selloff in markets over recent days on uncertainty surrounding the coronavirus, many technical indicators are now suggesting the market is becoming stretched to the downside and the risk/reward ratio is improving. Unlike a few weeks ago, or even a week ago, markets are starting to price in bad news. The bar for positive surprises has moved from very high to low. This is encouraging from a market perspective.

Our view is based on several indicators that are at or moving toward an extreme and indicative of indiscriminate selling.

  • The percentage of stocks in the S&P 500 above their 50-day moving average price has moved from 82% recently to 23%. This is the lowest level in more than a year. A level below 20% is considered oversold, a sign that market selling is becoming overdone.
  • The percentage of S&P 500 stocks making fresh one-month lows has spiked to 63%, the highest level since the tariff-induced August 2018 selloff. This is another sign of indiscriminate selling.
  • Over the past five days, the percentage of volume going into advancing S&P 500 stocks has moved to just 15%. Based on this metric, this is the most extreme selling we have seen since August 2015 and near the lows following the China growth and devaluation concerns. This indicator is even more extreme than the level hit during the late December 2018 selloff, also near a market low.
  • The volatility index (VIX), a measure of fear and investor demand for downside market protection, spiked to 30. This is the highest level since it reached 36 during the late 2018 market selloff.
  • The ratio of the VIX to the 10-year US Treasury yield is another measure of risk aversion that has moved to an extreme. This indicator typically rises sharply when volatility jumps during a market correction and there is also a flight to safety that pushes US Treasury yields lower. This indicator is now at the highest level since October 2011, the period that included the US debt downgrade and European crisis; the current level is also comparable to what was reached in August 2015 around China concerns (chart below).
  • There has also been a spike in demand for exchange-traded funds (ETF) that benefit if the stock market trades lower, with volume into these securities at the highest level since late December 2018. This tends to be a contrarian indicator at extremes.
  • Demand for protection in the options market is also picking up from the complacent levels that had concerned us and left the market vulnerable to bad news earlier this year.

The ratio of the VIX to the 10-year US Treasury yield has spiked to the highest level since October 2011, after the US debt downgrade and European crisis.

Bottom Line

Much uncertainty remains regarding the coronavirus. It is already a human tragedy. It may get significantly worse. If it does, markets still have much more downside. However, it rarely pays to invest on the worst case scenario, though it does make sense to have a diversified portfolio to help cope with uncertain outcomes.

Based on what we know today, our best estimate of downside from current levels for the S&P 500 is likely limited to about 5% to 7%. (see, Market Perspective: A Look at Past Corrections and Estimating Downside Support, 2/25/20). This analysis combined with the extreme selling suggests that investors who hold excess cash or are underweight their equity target should lean into the weakness and uncertainty.

To be clear, this is not meant to be some type of heroic short-term bottom call or to imply that risk is low or there is limited downside. Instead, we focus on the weight of the evidence in our work that suggests an improved risk/reward backdrop. Also, it is very important for investors to recognize that corrective periods tend to have a time element. The current setback is only four days long versus an average of 47 days (median 28 days) during this bull market. Thus, investors should be braced for wide price swings in both directions in the days and weeks to follow. It is also important to remember that fear and greed can trade places quickly.

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CN 2020-0474 EXP12-2020