As stock market investors have learned over the past week, it’s tricky to time the next move in the Dow Jones Industrial Average after a big selloff. Buyers stepped in Monday after the 900-point Nov. 26 dive, but there were signs of weakness. Stocks tanked Tuesday, soared back Wednesday before whipsawing into the close, and then had a huge day on Thursday before ending the week’s trading with a nearly 2% loss for the Dow.
“Always tricky,” says Keith Lerner, co-chief investment officer and chief market strategist at Truist.
Looking to market history can help.
Some are betting on the Santa Claus rally for a big December, even as clarity on the omicron variant threat remains lacking and cases spread, including in the U.S. And even after a week in which Fed Chair Jerome Powell surprised the market — with timing that was “curious,” according to Mohamed El-Erian — saying the Fed’s taper may be accelerated and inflation should no longer be described as “transitory.”
Traders work in the S&P 500 options pit at Cboe Global Markets Inc. in Chicago, Illinois.
Daniel Acker | Bloomberg | Getty Images
Lerner is looking to market history, and he sees an environment in which the patient investors will be ahead, if not in December, a year from now.
“We want at least a 12-month trend, because even if your entry point is not exactly right, you have greater chances of success in that timeframe,” he said.
The “Black Friday” Nov. 26 spike in the VIX volatility index of 54% was among the five biggest single-day volatility moves in the past three decades. Since 1990, there have been 19 trading sessions during which the VIX spiked by 40% or more. In 18 of those 19 instances, or 95% of the time, the S&P 500 Index was higher one-year later, and the gains were large — an average of 20%.
With the U.S. market still up more than 20% this year even after the recent volatility, another 20% might be aspirational. Lerner noted that before the recent market whipsaw, stocks had gained 9% since early October, and that is a negative as far as having confidence the market will move up substantially in the short-term. That implies the immediate future is “vulnerable” to more moves down.
But the more important data point is the longer-term trend in the VIX history: there isn’t any instance across the 19 biggest VIX spikes of the past three decades after which stocks weren’t positive a majority of the time one month, three months, six months, and one year later. One month later, stocks were only up an average of 1%, but were positive 70% of the time, and the numbers get better with time.
The caveat: Covid is a type of risk that the markets have not seen often over the past three decades, and two of the biggest VIX spikes came as Covid first hit the U.S. in February 2020. After both, the one-month period for stocks was brutal. That implies a market that remains on edge for now, and that should not come as a surprise — especially after the past week of trading. But the only of the 19 instances in which stocks were still down a year later was at the onset of the financial crisis. That data point gives Lerner more confidence in remaining bullish.
Volatility will remain the headline before the dominant trend returns, but that trend, he says, will be an economy that continues to expand and support further stock gains.
“In the last decade, we’ve had these V-shaped recoveries. They have been more normal,” he said. “Go back to the pandemic low, when you had a sharp move down and you get a kick back rally and a battle between greed and fear ensues. But in general, over the last 5 to 10 years, we’ve seen more of these come-down and go-back-up markets, as if nothing happened,” he added.
The last time was the end of September when the financial issues at Chinese property giant Evergrande sent the global equity markets into a tailspin.
Fear of missing out in a Covid market
The base case, Lerner says, is more of a tug-of-war until more of the news filters out and the market is able to get a better gauge on this new variant. This doesn’t change his view that investors are more likely to be rewarded by sitting tight rather than sitting out the market. In a “fear of missing out” era, that’s a lesson many investors learned from Spring 2020, the fastest bull market in history based on S&P 500 price gains.
“For people who missed out that time, it is a reminder about becoming too negative too fast,” Lerner said. “Even if you had had all the news on the pandemic, you would have been better staying in the market. By the time we have the all clear the market has moved,” he said.
The stock market was at a record shortly before Nov. 26, and when markets come off new highs, history says investors should be prepared for more downside over the next one to three months. A pandemic may heighten that volatility since the science is a type of uncertainty the market isn’t accustomed to analyzing. But the market does now have the 2020 Covid playbook to learn from.
“In February 2020, it was all new,” Lerner said. “We didn’t know how businesses would adapt, and now there is playbook. We saw they become more digital. There will be winners and losers, no matter what, but companies and consumers have adapted and will again.”
The Federal Reserve is on record as saying one of the lessons of the Covid era is that the economy has gotten better at adapting to pandemic during each successive wave. When Fed Chair Powell outlined a more hawkish position during Senate testimony this week, some market pundits pointed to the inflationary risks from an economy that is too hot as being the larger concern than a new Covid variant.
Like many market experts, Lerner says on the margins inflation may become even worse because of an exacerbation of the existing supply chain issues, which were starting to show signs of easing and now with a new variant unknown could go back up again on new factory shutdowns and delays in transportation.
“It is a risk to the market,” he said, and another reason volatility may remain elevated in the near-term.
Fed Chair Powell said this week that the omicron variant “complicates” the inflation picture.
But another difference between now and Spring 2020: the economy is not in a recession, which it quickly entered during lockdowns and stay-at-home orders during the initial Covid wave. “Now we know, even with this variant, it may slow activity down, but I still think recession risk is low. That’s a key difference from February and March 2020 when a recession happened so quickly,” Lerner said.
Apple, mega-cap tech stocks and the S&P 500
For investors who maintain broad exposure to the U.S. stock market through S&P 500 funds, composition of the U.S. stock market is a reason for riding out the current period of volatility. While Apple, the market’s largest company, took a dip on Thursday after a report its holiday sales of iPhones might disappoint, earlier in the week Apple shares, and tech more broadly, were a bright spot for the market in its rebound attempts. Apple, in particular, had the characteristics of a “flight to safety” trade. And with Apple and its mega-cap tech peers representing close to one-quarter of the S&P 500, the omicron overhang on stocks may do more damage below the surface of the index than at the surface gain or loss level.
“Especially in the U.S. market, composition does matter,” Lerner said.
Reflation trades may ultimately benefit if omicron doesn’t turn out to be as bad as feared and the economic expansion remains on track, but “right now, the strongest sector is tech and that’s the most important sector for those investing at the index level,” he said. “If the big mega-cap tech stocks hold up, you may see the headline index hold up better and more bifurcation below the surface. The knee jerk is investors will rotate to companies that can still create a lot of cash flow and have bigger balance sheets, so if there is a slowdown, they have enough to get through. They’ve become more defensive in some ways,” he added.
This view also makes Lerner in favor of continuing a tilt to U.S. equities versus peer markets around the globe, even as international and emerging markets trade at significant discounts to U.S. stocks. He noted that international equity prices are making fresh lows relative to the U.S., and in the case of the EAFE index versus the S&P 500, a relative price that is at the lowest level in history.
The sector composition of the S&P 500 and outsize role of mega-cap is a major reason for that versus the European market and the EAFE universe, in which financial and industrials are the top two sectors. Lerner stressed that this doesn’t mean gains won’t eventually come to those who enter early into discounted overseas equities trades. In fact, he has told clients that part of sticking with a U.S. equities tilt and technology for now likely means missing the onset of an investor rotation that is inevitably going to favor overseas markets as earnings power improves, but it’s a price he is willing to pay.
“Valuations are cheap overseas but that hasn’t been a catalyst,” he said. “We will miss the turn, but we are willing to wait for stability and earning trends, and that has served us well in being overweight U.S. … If there is a sustainable move, there should be sustainable upside,” he added. “You don’t need to be a hero trying to buy those markets.”
Short-term market headwinds, longer-term stock catalysts
Equity market strategists remain cautious on any sustainable bounce in the U.S., too, based on this past week’s action. Monday’s big really featured an advance/decline breakdown of 1,834 winning stocks versus 1,502 losing ones — “not a resounding up day.” Lerner said. But Thursday’s big bounce was more encouraging. Advances: 2,525. Declines: 868. “You want to see an advance-decline that is three-to-one,” Lerner said, and the market delivered that on Thursday — though that confidence didn’t last.
The Russell 2,000, a broader look at the U.S. market and domestic economy than the large-cap S&P, broke it’s four-day losing streak on Thursday, but by Friday’s close was 12% of its 5-week high. Lerner’s says the action in the small-cap Russell 2000 is an example of the “nice kickback but more mixed below the surface” market action investors will need to keep an eye on, and not let themselves be fooled by any “all clear” signal amid the stock nibbling and, most importantly, continued uncertainty over the course of the omicron variant.
The market had its best day since March 2021 on Thursday, but strategists remain wary. Tom Lee’s Fundstrat Global Advisors, which called for “aggressive buying” early in the week, said after both the Monday and Thursday rallies that the market wasn’t sending an all-clear signal.
According to Bank of America and FactSet Research Systems, headed into Friday’s trading action only 32 S&P 500 stocks were off their highs less than the S&P 500 Index.
“Thursday’s rally, similar to Wednesday’s bounce, failed to show sufficient strength to think a low is in,” Fundstrat Global Advisors wrote to clients on Thursday night. “This rally could still weaken further into next week. … Given the extreme drop off in breadth in recent weeks, a monumental effort is necessary along with broad-based participation to have confidence.”
On Friday, the S&P 500 barely avoided its sixth-consecutive trading session with a move of 1% or more, declining by 0.8%.
Lerner pointed out in a note to clients last Thursday that the percentage of retail investors with a bullish view has dropped to just 27% versus 48% a few weeks ago, according to the latest survey from the American Association of Individual Investors (AAII), while the percentage of bearish investors jumped to the highest level in more than a year. He sees investor patience as being as important as confidence. Corporations and consumers have adapted to Covid, pent-up demand remains, and the economy remains on solid footing, all which leads him to that bottom-line takeaway that the primary market trend is higher, but it will likely continue to be a rocky near-term road.
On Friday, the World Health Organization said the omicron variant had spread to 38 countries and early data suggested it was more contagious than the Delta variant. The tech sector led losses on Friday, with the Nasdaq Composite down 1.9%, and below the surface of the mega-cap tech leaders, many price-to-earnings ratios in the software sector remain vulnerable to revaluation even amid bets on the return to a more virtual, stay-at-home world, with the selling in DocuSign after its weak outlook an example.
While the S&P 500 is below its peak from a month ago; the ARK Innovation ETF that made fund manager Cathie Wood a star in recent years and during the pandemic: now down 40% from its February high and its largest pullback since the onset of the pandemic. The iShares Tech-Software ETF, which includes DocuSign, was below its 200-day moving average for the first time since May on Friday, and more than 14% below its intraday all-time high from November.
The one factor investors should not let set their investment course is fear. Fear in the market right now is being driven by a factor that is real, and to get to the other side of that fear can takes weeks, if not months. But fear can also rotate from a market headwind to market tailwind, and that is what the history of big spikes in the VIX index shows. “The same fear becomes the catalyst,” Lerner said.
After the “Black Friday” selloff, Lee said the lack of an inversion in the VIX, when the nearer-term risk is being priced higher than the outer risk, was a positive sign. But by this past Friday, the VIX curve had inverted, which is a sign of portfolio stress. While that “can occur near the climax of a selloff, as fear peaks,” the VIX will have to un-invert again for more confidence.
“We have to say with humility what we know and don’t know,” Lerner said, but he added that if the catalyst for the S&P being down is renewed Covid fears, and we find out these concerns are overblow and won’t disrupt the economic trajectory and won’t effect corporate profits, the headlines that had people braced for negative news become a positive catalyst for the market because expectations were reset lower.
“There are times like 2007 when investors weren’t fearful enough,” he said. “But our baseline view is that we’re not going into a recession, this doesn’t change the economic expansion materially.”
Friday’s monthly jobs report was below expectations in number of jobs added by the U.S. economy in November, but it was a mixed report, with the unemployment rate falling and labor participation rising, both encouraging signs for the economic outlook.
A “garden-variety” correction in stocks, was how S&P 500 technician Ed Yardeni described it early last week.
By Friday’s close, the Nasdaq was down more than 6% from its 52-week high; the off Dow over 5%; and the S&P less than 5% from its annual high.
“5% to 10% corrections are the admission price to the market,” Lerner often says. “Investors are better served by focusing on the longer term trend.”