Time to Read: 6 minutes
After weeks of coronavirus news coverage and considerable handwringing, markets (finally) took a steep tumble as the fear factor intensified. With the virus spreading to more locations—making it clear that China’s quarantine efforts have fallen short—and the Centers for Disease Control and Prevention warning Americans to brace for a widespread outbreak, investors are increasingly concerned about a decline in global growth and business activity. On February 25th, the Dow Jones Industrial Average posted its worst two-day loss on record after shedding more than 2,000 points while the 10-year Treasury note yield fell to a new all-time low.
Much like the sharp downward move seen in February 2018, this week’s volatility arrived after a long period of calm. Less than two weeks ago, we advised investors to examine their risk profiles given the delicate combination low volatility, all-time market highs and a 10+ year streak without a 20% correction. While we did not expect an imminent correction, we were positioned defensively with an underweight allocation to equities. Here we look at what may come next, including how markets could react based on sentiment and the upcoming presidential election.
Crowds as a contrarian indicator: Beware the herd during market extremes
We closely monitor the Ned Davis Research Daily Sentiment Indicator. The indicator, which had been well into the “excessive optimism” zone, recently changed course—a move which usually indicates low market returns and increased risk. This week’s market correction pushed the indicator into the “extreme pessimism” zone, which has typically been a reasonably good entry point for stocks. The orange line below illustrates this reversal, with the circles highlighting the recent high and low points.
Ideally, we would like to see the indicator dip even lower in the coming days or weeks to create a more attractive buying opportunity. As the crowd becomes more pessimistic and the market sell-off potentially intensifies, we’re looking for opportunities to take the contrarian position as buyers.
What about the election? Markets hate uncertainty
In early 2020, investors seemed to feel relatively sanguine about the risk posed by political uncertainty in the US. Typically, markets are weak during the first half of an election year as investors grapple with who will win a seat in the White House, as shown below. This year, however, the lack of a clear Democratic frontrunner led investors to view a second Trump term as more likely. Markets hate uncertainty, so another four years of a Trump presidency reduced political risks.
But wait: The convincing victory by Bernie Sanders in the Nevada caucuses last week brought political uncertainty back to the forefront. Furthermore, the coronavirus may threaten Trump’s reelection prospects if an outbreak hinders the US economy or his administration is viewed as having mismanaged the response—potentially adding to the political uncertainty.
Market declines are part of the game
After a great year like 2019, it’s important to remember that stocks offer such attractive long-term returns because those returns come with significant volatility. In fact, the S&P 500 averages 3.4 declines of 5% or more per year, as shown below, and these dips have historically had a 32% chance of developing into a moderate correction of 10% or more.
Where do we go from here?
As we recently explored, there have been six global health emergencies since 2003, and in all cases, the market was higher 12 months later after an initial “fear” decline. We have serious and genuine regard for the human toll of the new coronavirus. As financial advisors, though, it’s our duty to examine the investment consequences. We continue to monitor objective indicators to see when (and if) the recent declines present advantageous buying opportunities in certain asset classes.
We entered the year underweight equities across all our portfolios, looking for an uptick in volatility partnered with a decline in sentiment to trigger an increase our positions. While it still might be a bit premature to add new investments across all our accounts, we are making a “shopping list” of what to buy when the time is right. Our first step would be nibbling at some bargains created during the sell-off with the intention of holding until a return to neutral, then assessing if and when it may be sensible to move to an overweight position.
Investment advice offered through Stratos Wealth Partners, Ltd., a Registered Investment Advisor DBA BWM Financial. Investing involves substantial risk. BWM Financial and Stratos Wealth Partners (the “Firm”) do not make any guarantee or other promise as to any results that may be obtained from the Firm’s “letter”. While past performance may be analyzed in the Letter, past performance should not be considered indicative of future performance. All indices are unmanaged and cannot be invested into directly. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. No reader should make any investment decision without first consulting his or her own personal financial advisor and conducting his or her own research and due diligence.