Panic over the coronavirus and the resulting market meltdowns have sent many abandoning stocks to seek the relative safety of government bonds or even credits.
However, bears may be waiting for a trough that has already occurred, says Peter van der Welle, a strategist in Robeco’s multi-asset team. It presents a ‘two-way’ risk for investors before more clarity is available, he says.
“The fastest slide of equities into bear market territory since 1929 evidences the unprecedented uncertainty surrounding the external shock to the global economy posed by the coronavirus,” Van der Welle says. “This has been aggravated by the sudden change of tack by OPEC+ in the oil market.”
“Although implied equity volatility has fallen from levels even exceeding the peak of the 2008 global financial crisis, visibility remains low, with equity volatility still around four times the historical average.”
The coronavirus is almost certain to usher in a recession, though the unique circumstances of lockdowns to prevent Covid-19 spreading means few have any idea what kind of economic damage – and any subsequent recovery – might result, he says.
“Although unprecedented levels of fiscal and monetary stimulus may very well dampen the downturn, solving the health crisis first is key in order to obtain some clarity on the most probable economic recovery path,” Van der Welle says.
“Yet, as investors we are not rewarded for waiting until the dust has settled, and the macroeconomic view becomes clearer. In confusing times like these, market technicals trump fundamentals in market pricing behavior. With major equity indices down more than 25% from the recent highs, the natural question is: how much downside in indices is left from a technical point of view?”
He says hopes that equities have bottomed out have risen following a record daily bounce of 11.45% on 24 March ahead of the USD 2 trillion stimulus package announced by the US Congress – but the market may still be in the denial phase.
“A daily return for the Dow in excess of 10% is extremely rare – it has only happened eight times since 1900,” says Van der Welle. “And it is not necessarily good news when put into a historical perspective. With the exception of post-trough moves in September 1932 and March 1933, all jumps in excess of 10% typically happened fairly early on in the bear markets around the Great Depression, the Great Financial Crisis and Black Monday 1987.”
“The first bounce of more than 10% in the 1931,1987 and 2008 bear markets was still followed by another wave of selling before the final trough emerged. From a sentiment angle, recent exceptional bounces suggest that investor sentiment is still in the denial phase, rather than in the phase of capitulation that paves the way for a new bull market.”
“By now, equities, high yield and investment grade bonds have fully priced average recession risk. However, the average recession does not exist, and this recession won’t likely fall into this category either, so we have to be more granular.”
What matters most for market timing purposes is not the ‘average’, but those kind of granular details, Van der Welle says. One good question to ask is: what were the specific preconditions under which this bear market emerged?”
“We find that the best variable to explain the variation around the average peak-to-trough returns for the S&P 500 Index is the Shiller CAPE (the Cyclically Adjusted Price/Earnings ratio) at the prior market peak,” he says.
“Allowing for the fact that we’ve had a historically high starting CAPE (31) at the February S&P 500 Index peak prior to this sell-off, the remaining downside in the S&P from the current index level is still more than 10%. The CAPE tells us to keep an eye on downside risk, as it could still be lurking in a corner of this bear market.”
So, is the worst over? Not necessarily. “Low visibility on the macro front, a state of denial in investor sentiment, unpredictable bounces of 10%+ and stretched US valuation levels are important clues that we might not be out of the woods yet,” Van der Welle says.
“However, the risk for bears is that they are waiting for a trough that already happened. External shocks like the one experienced in recent weeks typically trigger shorter recessions and sharper recoveries, which markets quickly anticipate.”
The unprecedented stimulus of central banks and increasingly of governments will be a factor in how long a recession lasts. Although economic activity will likely normalize on a 12-month horizon, these are testing times, and it is uncertain which side tips the balance for equities in the near term.”
“There is therefore obvious two-way risk for equity investors at this juncture, which leaves us preferring to adopt an overweight in credits and high yield bonds instead of equities to position for the eventual economic recovery.”
“These asset classes are increasingly bought by central banks, they tend to lead equities in the business cycle, and have sold off more than was warranted for average recession risk, which makes them relatively better value now than equities."
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