The aggressive selloff we saw in US equities (SPY) in March brought investors’ interest in stocks, as they have been questioning if it could be seen as a good opportunity to buy the dip. The announcement of QE-Infinity combined with the $2 trillion stimulus generated a sharp rebound in the market, with SPY registering its third-biggest weekly change in the index history, following two weeks of total chaos (Figure 1).
However, we think it is still way too early to pile into stocks, as uncertainty around the duration of the shutdown remains high. Impatient investors who are buying the dip may face another aggressive wave of selloff as the global economy falls deep into a recession.
Source: Eikon Reuters
Bear markets can last for a while
First of all, it is important to emphasize that bear markets in equities can last for a while, and even though large drawdowns tend on average to be followed by big rallies, we are clearly not confident that it will be the case this time, as economic fundamentals are about to plummet in all of the developed economies. Figure 2 shows 10 episodes of bear equity markets in the US in the past 90 years. We can notice that the 2020 selloff is the second quickest one in the history of US equities (the October 1987 crash was the quickest one), but previous recessions show that the S&P 500 could continue to fall much further in the coming weeks. For instance, the market collapsed by nearly 90% during the Great Depression during a total period of 696 business days.
We have not entered a recession yet (two following quarters of negative GDP growth), and investors are already trying to buy the dip. During the 2008 Financial Crisis, equities bottomed in March 2009, 12 months after the economy was experiencing a negative downturn. Buying equities without knowing the duration of the lockdown and governments’ new measures for the coming months concerning social distancing is very risky. This bear market is here to stay.
Source: Eikon Reuters, RR Calculations
Yield curve inversions and equity markets
Last year, the ongoing tensions on the trade war with the imposition of additional tariffs on Chinese and American goods, combined with the rising uncertainty around the world (i.e., Brexit, yellow vests movement…), led to an important market event in August 2019: the inversion of the well-known 2Y10Y US yield curve. Figure 3 shows the dynamics of the yield curve since 1976; each inversion has traditionally been followed by a recession with an average of 21 months. We can notice that the business cycle can last for another 2 years after the yield curve inverts, but this time the US will enter a recession within the 12 months following the inversion.
The pace of US economic activity peaked in the last quarter of 2018 and was already slowly down last year, and many investors were waiting for a major catalyst that would send the whole economy into a tailspin. Even though equities did not react to the sharp increase in fundamental volatility in 2019, COVID-19 was the unexpected and unfortunate event that drove that all asset prices massively lower within a few weeks of trading. Consensus currently forecasts a strong recovery for the second half of this year, but we think that is too optimistic, and our base-case scenario predicts a sluggish growth in the third quarter of 2020 due to social distancing. We think that economies will reopen partially at first, keeping all the activities and events that gather a significant amount of people shut in the first few months (i.e., football games, museums, bars…). How can you expect the world’s economic activity to boom in the second half of 2020 when the uncertainty of all the employees’ status is at a record high? We think that US consumption will drop sharply in the coming months, as households will save carefully amid rising concerns that their business or company will shut down.
Source: Eikon Reuters, RR calculations
The 2Y10Y yield curve is often used as one of the key inputs of popular leading economic indicators, as it tends to efficiently lead a diversity of market data. For instance, Figure 4 (left frame) shows that a flattening yield curve has been usually followed by periods of high volatility (usually 30 months later). We are now facing a high-volatility regime that can last for a while; this implies that all the target-vol portfolios and levered strategies will have to readjust in the medium term and, therefore, sell risky assets to match their mandate.
Elevated implied volatility is the number 1 enemy of equities. Figure 4 (right frame) shows that in the past 30 years, equities have averaged -75bps in monthly returns when the VIX was trading above 20; this is an important chart that investors need to have in mind each time they buy equities in periods of high volatility. Highly volatile regimes are usually good for traditional “safe havens” such as gold, US Treasuries and some currencies (USD, JPY).
Source: Eikon Reuters
Biggest risk for equities in 2020: COVID-19 crisis to switch from a health crisis to a social crisis
The past few weeks were marked by radical changes in central banks’ policies, as the COVID-19 escalation has led to a global shutdown, raising the risk of a global depression with massive waves of unemployment coming in all the countries. We saw last week that a total of 3.28 million people filed for unemployment insurance in the US in the week ended March 21st; it is clear that, in the coming weeks, the world is going to experience the highest and weirdest rate of change ever observed in the history of all indexes. The risk is now that we switch from a global health crisis to a global social crisis, with riots emerging in all parts of the world and extreme parties gaining popularities in response to the high unemployment rates. Academics research has been emphasizing the rise of inequalities in the developed world in the past cycle, and a significant part of the studies have been blaming central banks’ interventionism as the major force behind the global inequality gap. Low interest rates, combined with large asset purchase programs, have been providing liquidity to the market and have resulted in higher asset prices globally, making securities holders richer on paper. In a public report, Ray Dalio studied the 40-60 inequalities in the US and finds that the top 40% now has on average 10 times as much wealth as those in the bottom 60%, up from six times in 1980.
Edward Wolff (2016) also studied the dynamics of household wealth in the US in the past 60 years and found that despite the sharp recovery in asset prices in the past cycle, wealth grew more vigorously at the top of the wealth distribution than in the middle. Figure 5 shows different US net wealth distribution ratios; we can notice that the percentage share of wealth or income held by the top 40% in the US has grown considerably relative to the bottom 20% in the past cycle, while it was relatively stable prior to the Great Financial Crisis. How long can this last?
Source: Wolff (2016)
Too early to buy the dip!
Historically, it is known that each time the market corrects, investors rush to buy equities in hopes that the market rises again and reaches new highs. Figure 6 (left frame) shows that investors would have generated a significant amount of money on average if they bought the dip following a week of negative returns (from close to close). We conducted this analysis using weekly returns in US equities since 1990. The three exceptions were in 2002, 2008 and 2018 (but the losses were minimal in 2018). Hence, investors are tempted to buy the dip each time market corrects, as it offers them the opportunity to enter the market at a “discount price”.
In addition, if we look at the 2W change, the temptation to buy the dip is at an extreme high, as US equities experienced their worst return in 90 years between March 6th and March 20th (-22.5%). This drastic selloff was followed by a 10.5 percent rise last week, with a lot of practitioners questioning if they had already missed the market’s bottom.
Source: Eikon Reuters, RR Calculations
We do not feel very confident in starting to build a long position at current levels, as there is still a lot of uncertainty concerning the duration of the lockdown in most of the countries. It is interesting to notice that the search “how to buy stocks” on Google Trends has skyrocketed in recent weeks, clearly indicating a negative signal for the outlook on equities (figure 7, left frame). A lot of people are rushing to buy stocks at a time when individuals should be very selective in each stock they buy, as a lot of sectors will continue to perform poorly in the coming months.
In addition, the increase in global liquidity may not be enough to levitate global equities in periods of economic downturn. Our excess liquidity measure, which we compute as the difference between real money growth and industrial production, tends to be a good 6-month leading indicator of risky assets such as equities (figure 7, right frame); however, periods of recession are marked by a significant rise in excess liquidity as industrial production becomes deeply negative and equities generally fall sharply.
Source: Google Trends, Eikon Reuters, RR calculations
In order to limit the downside in all asset prices, the Fed has announced unprecedented liquidity measures in addition to QE-Infinity until the situation improves. Last week, the Fed purchased $625 billion of securities ($75 billion of Treasuries and $50 billion of MBS every day), $25 billion more than the entire QE2 that ran for 7 months between November 2010 and June 2011. This corresponds to an annualized pace of $32.5 trillion. The Fed’s balance sheet is now north almost $2 trillion since its Q4 2019 lows, bringing the total to $5.5 trillion (27.5% of the country’s GDP). We expect the Fed’s balance sheet to increase up to $8-9 trillion this year, or 40-45% of the country’s GDP (the ECB balance sheet is currently 40% of euro area GDP).
As we mentioned earlier, the impact on stocks may not be imminent, and we could see further decline in US equities while the YoY change in the Fed’s assets keeps increasing. Even though investors like to overlay US equities with the path of Fed’s assets, we think that we could have a divergence between the two times series, as represented in Figure 8 (left frame).
Source: Eikon Reuters
Outlook on SPY
We would wait for lower volatility before stepping back into equities, as we think that SPY will experience another significant selloff in the near to medium term. Reduced buybacks combined with people tapping in their 401(k) funds to finance their short-term obligations are both negative forces for equities; in addition, the compounding effect of uncertainty will force a lot of funds to deleverage their risk in the coming weeks. Unless the Fed starts to buy equities aggressively, marginal buyers of equities will be very limited, increasing the risk of facing another drawdown.
The SPY broke below its long-term upward trending support line in March, which some considered as the crucial support of the past cycle, and also broke below its 38.2% Fibo retracement of the 68.3-338.2 range, before consolidating back above 250 last week. The death cross, when the 50-day SMA breaks below the 200-day SMA, is now indicating a strong selling signal, limiting the upside gain in the near term. We think that any short-term bull bounce could be seen as a good opportunity to short SPY again, as we expect another leg of selloff soon.
Source: Eikon Reuters
In Figure 10, we take a closer look at the dynamics of SPY in the past three years. Using an Elliott Wave analysis, we can notice that we have entered in a three-wave consolidation period (A-B-C) and that the recent rebound will soon be followed by another drop in markets. The second wave of selloff will bring SPY below the 218.2 low hit in March; we could actually see a consolidation towards 203 (50% Fibo retracement of the last 11-year range), implying a 50% drawdown from peak to trough.
Source: Eikon Reuters
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Disclosure: I am/we are short EURGBP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.