Markets

This is a wounded, fragile stock market raging for a proper policy response

Traders work on the floor of the New York Stock Exchange,  March 12, 2020.
Brendan McDermid | Reuters

Markets always rush to price in future economic conditions and often overshoot in the process. 

But can the recent near-30% crash in three weeks through Thursday have properly discounted an economic path now being set by an intentionally extreme reaction to a global health threat? (The sell-off was on again with stock futures pointing to big losses again at Monday's open.)

It's impossible to know for sure and probably foolhardy to hazard a confident answer. 

What we can do is survey the wreckage, compare the action to prior severe stock-market collapses and stay alert to collateral issues that will almost certainly surface.

The only past episodes that compare closely with the speed, intensity and breadth of the selling in recent weeks are the 1987 crash and the 2008 post-Lehman panic. Elements of the sovereign-debt scare of 2011, the post-9/11 period and the late-2002 surrender phase of the tech-bust bear market are there, too.

On a score of measures — the percentage of stocks below their 200-day average, the volume of falling to rising stocks, the average size of daily index moves, measures of urgent downside hedging — last week's extremes match up with those somewhere near the end of an initial market shock. 

'Total disarray'

Larry McMillan of trading-advisory firm McMillan Analysis on Friday said, "Markets are in total disarray. I traded through the crash of '87 and through the financial crisis of 2008, and this is worse." 

Worse in the sense that typical index levels that might have been expected to slow or pause the decline hadn't, the day-to-day velocity grueling. The relentlessness of this sell-off is the angry mirror image to the unrelenting rally to all-time highs, when the indexes set records for streaks without even a 1% daily move. 

Bespoke Investment Group's chart of net advancing stocks over 20 days shows the utter washout conditions that helped set up Friday's wild 9% rebound. 

If in fact the market is near the end of that initial shock phase of rapid liquidation and swelling fear, it would not remotely mean a solid bottom is in and calm is at hand. But if history holds, it could mean the bulk of the damage has been done for the moment. 

After selling climaxes in late 1987, 2002 and fall of 2008, the market saw high volatility, retests of the low and ultimately lower index levels over ensuing months.

Typically, this phase would see headlong rallies that fizzle, air pockets opening up without warning, and a messy reckoning with the evidence of the economic damage that the near-vertical market drop had been handicapping.

Ned Davis Research strategist Ed Clissold notes that Friday's upside reversal came with some 95% volume in advancing stocks. In order to have conviction that Thursday's low was consequential, he says several more such days would be needed, without an intervening 10:1 downside day.

For some perspective, the S&P 500 could rally 10% from here and still prove nothing more than it's bouncing from extraordinarily oversold conditions, retracing merely half the recent peak-to-trough drop. 

'Wounded, fragile market'

It's a wounded, fragile market, raging for a proper policy response and whipped around by misfiring trading strategies that relied on a choreography of asset-market relationships that have been thrown into chaos. 

The most crucial relationships that have been contorted are among stocks, Treasuries and corporate bonds. In the climactic collapse on Thursday, when the S&P 500 lost 9.5%, everything was for sale, including Treasury securities, whose yields rose in apparent violation of their typical behavior.

Some of this reflects a general liquidation of all assets and a rush into cash, which is visible in record inflows into money-market funds last week.

But the equity-Treasury interplay was also thrown off by the retreat of large systematic funds that own stocks against leveraged Treasury portfolios, on the idea that losses in stocks will be made up by Treasuries rallying. Yet with Treasury yields so close to zero, there is so little room for Treasury prices to rise further to offset equity losses, that they simply reduced their holdings of everything.

(Treasury yields were falling again overnight Sunday.)

This flight by quantitative funds might be largely through, based on several measures, such as this gauge by Deutsche Bank. This is another hint that at least the indiscriminate liquidation phase of a market shock might be running its course.

Corporate credit is probably the most vexing battlefront from this point. Investors last week registered fresh anxiety over companies in several industries being able to service their debt. Risk spreads on both junk and investment-grade debt made multi-year highs as companions moved to draw down backup credit lines. 

After an 11-year expansion, Corporate America's balance sheet is not set up to withstand what could be months of nasty revenue declines - nor should we expect it to be. 

This is where the market has grown twitchy for assurance form the Federal Reserve and Congress to cushion certain industries against sudden business halts. 

How can you value stocks?

Valuing this stock market is like stumbling through a thick fog. At Thursday's lows the S&P 500 forward price/earnings ratio dropped to 14, near where it bottomed in late 2018, but current profit forecasts are likely laughably too high. And Friday's pop alone added more than a point to that forward P/E, laughably.

The market was richly valued at the peak and it's hard to argue any core valuation support has been located yet. 

But value is certainly being surfaced, given the heedlessly comprehensive losses across stocks and sectors, punishing the guilty and blameless alike. Nearly $10 trillion has been wiped from U.S. stock-market value in less than a month. Just a start, or enough for now? 

Plenty of alarmed observers will say that history is of no help in understanding how the market will act from here. And of course, the specifics are extraordinary, a modern world economy going on indefinite partial lockdown. 

But when World Wars, oil shocks, terrorist attacks on U.S. soil and a freeze of the global banking system occurred, they were all unprecedented in detail too. But the way human behavior reacts to threats, and how markets metabolize uncertainty, tend to rhyme. 

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