The trading action in recent days certainly shows that the smell of fear is in the air. The bears won last week’s battle, even as they’ve been losing the war for years.
The Standard & Poor’s 500 index had one of its worst few consecutive days ever, declining a stunning 12.8% in seven days. Such decline velocity was last seen in 2008.
Cue the panic. The mounting hysteria around COVID-19, and a growing consensus that “nothing is safe” is only amplifying the view that equities will not find a floor until the world is past “peak Corona virus” spread.
The fog of losses is obscuring investor vision, but I think that in the past month, and particularly in the past week, significant divergences between asset markets suggest that the SPX might see a catch-up trade that leads to a “V-shaped bounce.” This is consistent with our commentary earlier this week that I believe there is a 60%-plus probability stocks are bottoming about now.
First, consider the stock market in China —the epicenter of coronavirus— bottomed three weeks ago (after falling 14%) and then had V-shaped 14% rally to within 2% of three-month highs. Think about this. China’s infections are still growing, with the economy at a virtual standstill, yet the equity market has staged a V-shaped rally.
Second, if a vast deterioration of US corporate fundamentals is being “priced in” by the equity markets, why have investment grade (IG) bond yields plunged to a 25-year low to 2.54% (2.97% on 12/31/2019)?
Contrast that to the 2007-2008 financial crisis, when IG yields rose from 5.5% to 6.28% (yearend 2007) on their way to 10%, which is what you’d expect if markets were worried about corporate fundamentals. Today, in 2020, we see a complete divergence between IG funding costs and the cost of equity, while in 2008, both rose in sync. (See chart below.)
Moreover, the spread between the SPX dividend yield of 1.93% and the IG yield of 2.54% is the narrowest in 25 years. This is a pretty unusual divergence, and in my view further supports why stocks could stage a V-shaped bounce. The average spread is 3.41%, meaning if dividend yield is 1.93%, IG yields should be 5.34% (not 2.54%). This is the narrowest ever spread, meaning stocks haven’t been this cheap since 1996. Think about that. The issuer is the same, so why should the funding cost of the bond be that much lower than the equity? By the way, these spreads were very narrow in Nov. 2012 and July 2016, two times that turned out to be very good entry points for equities.
Third, there have been 10 times since 1948 when stocks fell for 6 consecutive days and saw cumulative declines greater than 8%. Ten out of ten times, stocks were higher 12 months later, with a median gain of 28.5%. Now the past isn’t always prologue, but more importantly, when the Purchasing Managers Index was greater than 50 at the time of the slides, stocks were higher 100% of the time 3, 6 and 12 months later.
Let me also point out that the so-called fear index, the VIX, touched 48 Friday morning, a level seen only at major turning points in 2010, 2011, 2015 and 2018. This is pretty indicative to me. Additionally, the forward months of the VIX futures show lower expected levels. In other words, the market is pricing in near- term event risk (hence, in backwardation). This level of backwardation is severe and shows markets see sharply higher risk of “event risk” in the near term. This, in our view, is often a sign of a market nearing a bottom.
Notably, despite the elevating fears of Corona COVID 19, the long-term U.S. Treasury bond yield curve is steepening. We have written about this extensively in the past and have shown the 30-yr-10-yr curve is quite sensitive to macro-economic shocks and changes. But rather than flattening, it has been slightly steepening. This isn’t what you’d expect ahead of economic troubles.
What could go wrong? Could a recession or bear market be starting? Price is signal and there is certainly a foreboding message in the plunge in stocks. There is simply fear about the ability of governments to stop the spread of corona virus. And investors want to step aside. But given the resilience of Chinese equities, investors should not get too negative. Moreover, as noted above, the key long-term yield curve 30Y-10Y has been resilient and arguably steepening, even as stocks have plunged.
Bottom line: I believe a V-shaped bounce is coming. The best bet is to stick with low volatility stocks. We have identified 15 low-vol stocks ranked in the top quintile of our DQM quantitative model. The tickers are LMT, JCI, CTXS, ADP, V, GL, AIV, AMT, CCI, SBAC, KO, JNJ, MRK, PPL and D.
Figure: Comparative matrix of risk/reward drivers in 2020
Per FS Insight
Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/10/2019
