The headlines have been awful. The human toll from the virus continues to mount. The economic impact is jaw dropping. And we’re told things are going to get worse this week.
Although stocks are bouncing in the early going Monday on the hope that the worst will soon be behind us, it is clear that stocks are in a bear market and that meaningful relief (I.E. Rallies that last more than a few days) can only come from good news on the virus front. Yes, the response by the Federal Reserve has been impressive. It’s true that the CARES Act will provide relief to families and small businesses. And to be sure, a deal between the Saudis and Russians would be a near-term positive. But the bottom line is the longer the virus sticks around, the more damage is done.
Last week, I opined that one of the big problems here is there isn’t an appropriate analog for investors to follow. The intentional shutdown of the economy simply hasn’t happened before. As such, I believe the stock market is in the process of attempting to figure out/discount what comes next.
So, this morning, I’d like to try and take a look at this question.
Changing Consumer Behavior
I think we can all agree that the longer the economy remains closed, the more likely it is that consumer behavior will change going forward. It is said that if you do something for thirty days (think diet, exercise, or in this case, reduced spending) it can become a habit. The point is that such a change in consumer behavior is bad for the economy and argues against the idea that the economy will suddenly reopen and return to normal. I.E. There isn’t likely to be an “it’s all better now” moment.
How Do We Get A “V” Here?
I’ve spent a great deal of time on the phone lately with colleagues and friends in the business. Most of us have a lot of gray hair and have seen our share of crises and/or bear markets. My challenge to each has been the same, “Sell me on how we get a V-bottom here – for either the economy or the stock market.”
It will suffice to say that the responses have been few. Well, except for, “the virus suddenly goes away” and “a drug/therapy solution is found,” of course.
Good News On the Virus Front Coming?
On the latter, I read some promising news on drug therapies over the weekend. Here’s a great piece from Dr. Scott Gottlieb in the WSJ that talks about two approaches that show serious promise. However, Dr. Gottlieb also warns that this is going to take a while.
“Some imagine that the coronavirus will run its tragic course in the spring, with the direst results avoided by intense social-distancing and other mitigation efforts, and then our lives can more or less return to normal in the summer,” Dr. Gottlieb writes.
“But that isn’t realistic,” Gottlieb says. “Even if new cases start to stall in the summer heat, the virus will return in the fall, and so will fresh risk of large outbreaks and even a new epidemic. People will still be reluctant to crowd into stores, restaurants or arenas. Schools may remain closed. The public’s fears won’t relent simply because there are fewer new cases.”
So, while I, like most folks, I presume, would love to think that will be able to go back to our lives like nothing has changed in the next month or so, it isn’t likely to happen.
Looking At “The New Normal”
From a stock market perspective, this means that there will be a “new normal” do deal with/discount. So, let’s think about that. As of Friday’s close, the stock market is off between -26.5% and -38.29%, depending on which index you are looking at (the former is the decline in the S&P 500 while the latter is the drop in the Russell 2000 Smallcap Index). Surely this discounts a fair amount of bad news. But the key question is, how much is enough?
Over the weekend, I saw reports that 29% of the economy has been taken offline due to forty-one states issuing shelter-in-place orders. So, using a completely unscientific approach, one could argue that a stock price decline of ~30% might be about right.
However, this is most definitely not the way Mr. Market’s game is played. No, there is a market multiple that gets applied to earnings which determines what is “about right” for each environment. Sometimes, a multiplier of 18-20 (or higher) is fine. At others, 12-14 might be more appropriate. Each is based on investors’ collective expectations of the future and how much they are willing to pay for each dollar of earnings.
The Bad News: Getting To “Enough” Can Be Painful
While we don’t have a good analog to follow for this particular crisis, we can look back at history and determine what the average decline during bear markets looks like. The goal of this exercise is to get a feel for how much might be enough.
According to Ned Davis Research, the stock market entered a bear phase on 2/12/20. At the low (which occurred on 3/23/20), the Dow had declined -37.1% in just 40 calendar days. For the record, NDR defines a bear market as follows: “A cyclical bear market requires a 30% drop in the DJIA after 50 calendar days or a 13% decline after 145 calendar days. Reversals of 30% in the Value Line Geometric Index also qualify.” In this case, it was the dive in the Value Line Index that qualified the current dance to the downside as a bear market.
NDR’s computers tell us that since September 1900, there have been 36 cyclical bear markets. The average decline for the DJIA has been -35.6% over a period of 399 calendar days. So, the decline of -37.1% is in the ballpark but the duration of 40 calendar days is super short relative to the historical mean.
We can then look at bear markets that occur during secular bull and bear cycles. Here’s NDR’s definition of a secular cycle: “A secular bull market is a period in which stock prices rise at an above-average rate for an extended period and suffer only relatively short intervening declines. A secular bear market is an extended period of flat or declining stock prices. Secular bull or bear markets typically consist of multiple cyclical bull and bear markets.”
During cyclical bears that occur within secular bull cycles, the average decline has been -21.8%. Whereas the average bear that occurs during secular bear cycles is -36.3%. Ouch.
Next, since lots of folks believe the U.S. entered a recession in March, we can also look at what happens during bear markets that are accompanied by a recession. NDR’s Ed Clissold reports that the average decline for bear markets that are accompanied by a recession is more along the lines of the declines during secular bear cycles – or about -36%.
So again, the Dow’s most recent drop of -37.1% to the 3/23 low would seem to be a fairly average “discounting” of the bad economic news that is to come. But lest we forget, the damage associated with the last two recessions was far worse.
And in a Barron’s report, David Rosenberg points out that since WWII, bear markets have “taken back” an average of 71% of the prior bull market’s gains (and a median of 54%). According to Mr. Rosenberg, if history were to repeat here, the S&P 500 could decline to either 1455 or 1798 (or a drop of between 28% and 45% from Friday’s close), depending on whether your statistical preference falls to the means or medians. That’s not good news.
Now For The Good News
However, a look back at history provides us with some good news as well. And as a card-carrying member of the-glass-is-at-least-half-full club, I feel compelled to close this week’s missive on an upbeat note.
You see, Ned Davis Research went back and looked at what happens to the stock market after a bad quarter occurs. In this case, they defined a “bad quarter” as a drop of 15% or more. And since the S&P dove by a nice, round 20% in the first quarter of 2020, the most recent quarter certainly qualifies.
Cutting to the chase, since WWII, after a quarter where the S&P drops by 15% or more, the index tends to enjoy gains that are more than double the historical norms for the ensuing one, two, three, four, and eight quarters.
For example, one quarter after a quarterly decline of 15% or more, the average gain has been +4.3% versus the average return for all quarters of +2.0%. And 85.7% of the ensuing quarters were positive.
Two quarters after the bad quarter, the average gain was +13.0% versus +4.2% and 100% of the two-quarter periods were positive. A similar story is seen three and four quarters later: +22.5% vs. +6.4% and +22.1% vs +8.7%, with the market rising 100% of the time.
And finally, two years after a big, bad quarterly decline, the average return for the S&P 500 since WWII has been +40.7% versus an average for all two-year periods of +18.0%. Oh, and the market was higher two years later 100% of the time. Yay!
So, is there a chance this time will be different? Absolutely. Again, I’m of the mind that the market can’t look on the bright side again until there is good news on the virus front. And when that occurs is anybody’s guess.
However, I think it is REALLY important to recognize that there will be upside ahead – as in significant upside ahead – once we get this virus under control. Oh, and I’d be willing to bet dollars to donuts that we will get it under control in the coming months.
In closing, let me add that for those of us with a propensity to look on the bright side, we can take solace in the idea that better days as well as opportunities for investing profits, lie ahead. And keeping this in mind as the news on the virus and the economy becomes downright discouraging might help.
Weekly Market Model Review
Each week we do a disciplined, deep dive into our key market indicators and models. The overall goal of this exercise is to (a) remove emotion from the investment process, (b) stay “in tune” with the primary market cycles, and (c) remain cognizant of the risk/reward environment.
The Major Market Models
We start with six of our favorite long-term market models. These models are designed to help determine the “state” of the overall market.
The biggest takeaway from Primary Cycle board is three are now three sell signals, two holds, and only one buy signal. And the lone buy signal may deserve a “yea, but” since neither the earnings nor the economic model are designed for the type of “full stop” situation the economy is experiencing now. Thus, my favorite models designed to help identify the “primary cycle” in the stock market remains negative.
* Source: Ned Davis Research (NDR) as of the date of publication. Historical returns are hypothetical average annual performances calculated by NDR. Past performances do not guarantee future results or profitability – NOT INDIVIDUAL INVESTMENT ADVICE. View My Favorite Market Models Online
The State of the Fundamental Backdrop
Next, we review the market’s fundamental factors in the areas of interest rates, the economy, inflation, and valuations.
There are two changes to report on the Fundamental Factors board this week. First, the Economic Composite has shifted from positive to neutral. However, it is safe to say that this model is woefully behind the rapidly deteriorating economic curve at this point. In addition, the Valuation Composite moved into the positive zone from neutral. This tells me that there is likely to be meaningful upside when this market makes the turn and moves into a new bull cycle. But for now, the question is how much the E will fall in the P/E ratios.
* Source: Ned Davis Research (NDR) as of the date of publication. Historical returns are hypothetical average annual performances calculated by NDR. Past performances do not guarantee future results or profitability – NOT INDIVIDUAL INVESTMENT ADVICE. View Fundamental Indicator Board Online
The State of the Trend
After looking at the big-picture models and the fundamental backdrop, I like to look at the state of the trend. This board of indicators is designed to tell us about the overall technical health of the current trend.
Now that the initial bounce appears to have run its course, the Trend board has slipped back into the red. Note that I’ve broken the Trading Environment into two components – a short- and an intermediate-term view. From a short-term perspective, our indicators suggest that stocks are now in a mean reverting mode while from an intermediate-term view, the market is still in a trending lower mode. This suggests that a bottoming phase “could” be starting and that any “test” of the low will be important.
Next, we analyze the “oomph” behind the current trend via our group of market momentum indicators/models.
The Momentum Board remains a good “tell” for the current state of the market. In short, there isn’t much good going on at the present time. I will also note that both the I.T. Volume and Breadth indicators are based on the NASDAQ index, which has been the best of the major indices in this cycle. AS such, even the modestly positive indicators need a caveat.
* Source: Ned Davis Research (NDR) as of the date of publication. Historical returns are hypothetical average annual performances calculated by NDR. Past performances do not guarantee future results or profitability – NOT INDIVIDUAL INVESTMENT ADVICE. View Momentum Indicator Board Online
Early Warning Signals
Once we have identified the current environment, the state of the trend, and the degree of momentum behind the move, we then review the potential for a counter-trend move to begin. This batch of indicators is designed to suggest when the table is set for the trend to “go the other way.”
The Early Warning board did a decent job alerting us to the likelihood of the traditional “dead cat bounce.” And now that the bounce has occurred, the tailwinds from the extreme oversold condition that existed have waned. So, from a short-term perspective, neither team has much of an edge. However, with sentiment readings remaining largely negative (which is positive from a contrarian perspective) the edge remains with the bulls from an intermediate- and longer-term view. Yet, it is important to keep in mind that the bears remain in control of the game at this stage and will likely continue to do so until some good news on the virus front materializes.
* Source: Ned Davis Research (NDR) as of the date of publication. Historical returns are hypothetical average annual performances calculated by NDR. Past performances do not guarantee future results or profitability – NOT INDIVIDUAL INVESTMENT ADVICE. View Early Warning Indicator Board Online
Thought For The Day:
These are the times that try men’s souls. The summer soldier and the sunshine patriot will, in this crisis, shrink from the service of their country; but he that stands by it now, deserves the love and thanks of man and woman. -Thomas Paine
All the best, David D. Moenning Investment Strategist
At the time of publication, Mr. Moenning and/or Redwood Wealth Management, LLC held long positions in the following securities mentioned: None
Note that positions may change at any time.
NOT INVESTMENT ADVICE. The opinions and forecasts expressed herein are those of Mr. David Moenning and Redwood Wealth and may not actually come to pass. The opinions and viewpoints regarding the future of the markets should not be construed as investment recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.
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