An Update On The Market — And What’s Next…
Last week, I wrote:
“When the next downturn begins, sellers will appear quickly as investors worried about high valuations will panic and sell before their gains disappear.
The question is when that selling will materialize — and, unfortunately, the answer is not apparent. I’m watching the market closely, looking for the telltale signs that a panic is developing. Despite the dip we saw across the market yesterday, my indicators still remain bullish. For now…”
Selling materialized last week and panic ensued, just as I expected. But no one expected the unprecedented speed of the decline.
At the open last Monday, the S&P 500 gapped lower and broke below its 50-day moving average (MA), the blue line in the chart below. By Thursday, the index had broken below its 200-day MA (red line), and we were in a correction.
I’ve also drawn a few dashed lines on this chart. The first two mark the 5% and 10% pullback levels — these are often considered important retracement lines. The lowest dashed line toward the bottom of the chart is a little different; it connects last week’s low with the lows from back in October.
That’s right. In the course of a week, sellers wiped out the entire rally that created so much excitement at the end of last year — a major retracement.
This was the fastest 10% pullback from new highs in the history of the S&P 500, which dates all the way back to 1928. Since we’re dealing with new-ish territory, there isn’t a clear path ahead. In fact, last week’s record-setting decline was followed by a major rebound on Monday. The Dow climbed more than 1,290 points — the index’s largest one-day jump in history. Then, Tuesday morning, the Federal Reserve announced an emergency rate cut in response to the coronavirus outbreak, sending the market down again.
What Happens Next?
However, just because we haven’t been through this exact scenario, there are a number of precedents that can help us place the current market environment in context.
At the end of last week, the seven-day decline was almost 13%. The chart below shows the last time the market fell this fast in a seven-day period. It was the summer of 2011, as the S&P 500 was falling more than 21%. (Despite this decline, this drop didn’t qualify as an “official” bear market because the Dow Jones Industrial Average only fell 19%, and the Dow is the index used to determine bear markets.)
The previous instance was October 2008 (below). This was almost six months before prices bottomed in March 2009. There were three more rapid declines over that time.
We also saw this type of panic in September 2001 and July 2002 (below). The September 2001 selloff coincided with the terrorist attacks that set off a panic.
The rapid decline prior to that was October 1987 (below). This came when prices were already off their highs.
We also saw this in May 1962 (below).
At that time, steel companies were negotiating with unions that represented workers in steel mills and a strike seemed increasingly likely. To prepare for the strike, steel companies increased production as manufacturers stockpiled steel so they could continue operating through a strike.
Steel companies also decided to raise prices so they could have a cash cushion to help them through the strike. President Kennedy didn’t like the price increase and he instructed government officials, including FBI agents, to visit company executives at their homes to express his displeasure while he made a speech about corporate greed.
Steel companies rolled back the price hikes, but stock market traders became nervous about the unprecedented level of government intervention in an industry during peacetime. Stocks sold off.
Prior to that, a decline accompanying the beginning of World War II happened this quickly. And there were several occurrences between 1929 and 1932 as the Great Depression unfolded.
I know that’s a lot of charts, but I wanted you to see what history tells us to expect over the next few months. In the past, selloffs like this were followed by tough markets. Some saw a short-term rally; others saw further declines. All saw weeks or months of consolidation.
Maybe this time will be different — but it probably won’t be.
In my opinion, we are not likely so see new highs for some time. We may see more sharp rallies (like we did on Monday), but the stock market is likely to retest the lows we saw last week.
In the coming weeks, long-term investors need to be selective and focus on stocks they are comfortable holding for the long run. Traders are likely to see opportunities develop as the market stabilizes.
Options are trading with large premiums. And that’s a problem, for now. Based on recent volatility, options are pricing in a potential decline of more than 14% in the next four weeks. The typical volatility premium factors in a move of about 3%.
I expect volatility to decline in the next week. And as it does, options trades like the ones we make over at my premium Income Trader service should become appealing. I also expect prices to remain in a range for some weeks. There’s no need to rush into stocks since there could be a better opportunity soon.
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