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By Pete Biebel, Senior Vice President

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Now that our clocks have been sprung ahead, our hearts and minds can turn to baseball. With Spring Training about half completed, and, oh yeah, with markets in turmoil, a baseball analogy might be a good way to explain the market’s recent extreme back-and-forth volatility.

Imagine throwing a baseball while underwater. It probably wouldn’t go very far. If two people were playing a game of catch underwater, they would need to be standing pretty close to each other. That mental image of two close by, submarine baseballers represents the market during normal, non-volatile conditions. In a market awash with liquidity, it takes a lot of effort to throw the market very far one way or the other. In such conditions, market depth is significant; large quantities of stock are offered for sale just above current prices and large quantities of stock are bid for at prices just below current levels. The market is comfortable. Traders are confident they can buy or sell large blocks of stock without moving the market significantly.

Now picture those same two people playing catch on the moon. They could, theoretically, be standing hundreds of yards apart. The same effort, which barely moved the ball underwater, would cause the ball to travel much further in a low-gravity, thin-atmosphere environment. The laws of physics still work, but the environment has changed considerably. That will be our mental image of the market in the days immediately following an air-pocket decline.

Stocks are suddenly trading at prices where very little stock is bid for, AND where very little stock is offered for sale at prices just above the new current levels. The market is on edge. Traders are unwilling to buy or sell many shares of a stock knowing that doing so would move the market AND they would have no confidence that they could get out of those trades without moving the market. Volatility begets thin markets, which beget more volatility.

A compounding factor in thin, volatile markets is that traders shift their focus to technical levels as guideposts to short- term activity. They watch for breaks of recent highs and lows and breaks of significant moving averages as triggers to take action. The problem with that is that many traders will get the same signal at the same time, inspiring a sudden one-sided wave of buying or selling. In a thin market, those actions can cause extremely large moves in the averages in a very short time.

Let’s say that I’m relatively bullish as a major average descends to near a significant moving average. I might plan to do some buying as the index neared that moving average with the knowledge that, the more significant that moving average is, the more fellow traders will be thinking the same thing. I would enter buy orders at prices near the moving average and simultaneously enter stop-loss sell orders at prices just below that level to limit my losses in the event that persistent selling forces the index much below that price level. Everything would be fine if the index gets much of a bounce from that level but think about what happens if/when the index breaks below that level. Not only would bears amp up their selling as that level was violated, but also all of the speculative bulls would simultaneously be getting stopped-out on their recent buys, exacerbating the selling.

Last week began with an all-day mega rally that saw the averages rocket through the vacuum left by the prior week’s steep decline. A brief Fed-rate-cut-inspired rally Tuesday morning closed the second of three gap-down openings from the previous week’s downdraft, but any bullishness the rate cut inspired quickly faded as banks stocks headed south.   The Tuesday advance stalled very near the 50% retracement level. Markets often retrace about half of a large preceding move. Recovering half the late-February decline would take SPX back up to about 3130; Tuesday’s high was about 3137.

The results of the Super Tuesday primaries fueled an all-day “Biden bounce” on Wednesday. Stocks streaked higher through the still thin atmosphere led by healthcare companies, but SPX again stalled in the mid-3130s. Significantly, neither SPX nor the NASDAQ Composite Index (COMP) was able to exceed their Tuesday high on Wednesday. Thursday and Friday each endured gap-down openings and significant losses on continuing coronavirus news. As was the case in the previous week, the averages all recovered a very large percentage of their Friday losses in the closing minutes of trading before the weekend.

That big closing rally lifted the major averages back into the plus column for the week. The Dow Jones Industrial Average (DJIA) was up about 1.8% net for the week. SPX gained about 0.6% and COMP, weighed down by losses in some big internet stocks, posted a mere 0.1% advance last week. Those are surprisingly small net changes for a week that experienced so many days with gains and losses of 3% or more.

Concerns over the expanding contagion coupled with the Fed’s rate cut led to surprisingly large gains in Treasuries as their yields plunged to new record lows. That helped interest rate sensitive sectors outperform more cyclical sectors. It also put a significant hurt on stocks in the Financials sector, which lost about 5% last week and more than 16% over the past two weeks. Only the Energy sector has had a poorer showing. That sector lost about 13 ½% last week and brought its two-week decline to about 21%. The price of Crude Oil, which was in the low-$60s as 2020 began, has been hammered by fears of slowing demand and ended last week below $42 per barrel.

One bit of good news is that the major averages did not fall below their lows of the previous week last week. Those lows will be important levels to watch in the coming days and weeks. If/when the indices break below those lows, it could ignite another rush of technical selling. One index that is already a cause for concern is the Russell 2000 Index of small- cap stocks (RUT). That index lagged its large-cap peers all last year. While the big boys all easily made new record highs  in 2019, RUT fell well short of its all-time high. Its recent skid has been much steeper than that of COMP or SPX. Worse, last week RUT dropped below its 200-week moving average and below its lows of last summer. RUT ended last week near 1450; it’s still about 11% above its December 2018 low near 1300, but if it loses much more ground this week, it would greatly increase the odds that the old low could be tested in the near future.

In late July of last year, in an article titled “Wake Me When It’s Over,” I noted the improving relative strength in gold and silver and wrote, “Both metals have infamously underperformed stocks continually over the last seven or eight years.

It’s been a constant reminder that neither metal should be a full-time portfolio holding. However, history has shown that there have been periods when gold and silver trend higher for years and dramatically outperform stocks. This recent strength may be a sign that owning a little gold and/or silver might be a reasonable consideration for the first time in years.” Gold in particular continues to shine; it’s up 17% since then and hit its highest level in seven years last week.

The following several paragraphs are a repeat from last week, but all those comments still apply. Feel free to skip ahead if you memorized last week’s commentary.

And, while there’s no telling when or at what level a bottom will be formed, it will likely include some distinctive technical features. It may very well come on a capitulation inspired shake-out with convulsive, blood-in-the-streets  panic selling. It will likely occur on a day with much higher than normal volume. It wouldn’t be a surprise if it came on a day with steep losses early in the session that reverse to end the day with a gain. And, the low will probably be very  near a key technical level. In the 2018 wash-out, SPX bottomed within a few points of its 200-week moving average.

Currently that average stands in the mid-2600s, about 10% below Friday’s close. Let’s hope we don’t have to see a replay of that feat.

We should expect to see volatile, wide-range days, both up and down. The rebounds should enjoy expanding longevity, lasting a few days rather than just a few hours. We should watch how the averages behave if/when they make lower lows. The more significant the follow-through on new lows, the more likely it will be that there’s more pain ahead. Our Fed along with other major central banks are likely to announce significant monetary easing measures. Such announcements, if and when they occur, will probably be responsible for starting or extending a rebound attempt.

Right now, the market has no way of knowing how bad the Covid-19 news might get, but we can get a sense of the market’s health by watching how it responds to headlines in the weeks ahead. When bad news no longer rattles the market, it’ll probably indicate that the lows have been seen.

What should we do now?

It might have been better to ask, “What should we NOT do now?” We should not panic. And, we should not close our eyes and wait for this phase to pass. Talk to your advisor. Market disruptions create opportunity. We’re probably just months, if not weeks away from the best buying opportunity of the year. While it may be too soon to buy aggressively, now seems like a great time to start putting together a shopping list of stocks or funds. Investors who recently throttled back on their equity allocations due to the recent extreme valuations may soon have an excuse to step on the gas and again rev up their exposure to stocks.

This week’s economic updates will still be reporting data from periods prior to the covid-19 outbreak. Only the Consumer Sentiment number on Friday could reflect more recent developments.

Date Report Previous Consensus
Tuesday 3/10/2020 NFIB Small Business Optimism 104.3 102.7
Wednesday 3/11/2020 Consumer Price Index, M/M +0.1% 0.0%
  Consumer Price Index, ex Food & Energy, M/M +0.2% +0.2%
Thursday 3/12/2020 Producer Price Index, M/M +0.5% -0.1%
  Producer Price Index, ex Food & Energy, M/M +0.4% +0.2%
  Initial Jobless Claims 216K 217K
Friday 3/13/2020 Import Price Index, M/M 0.0% -1.0%
  Consumer Sentiment 101.0 95.0

 

Links to previously published commentaries can be found at benjaminfedwards.com/For Our Clients/Educational Resources/Market.

March 9, 2020 |