US stock market may be in a holding pattern

Key takeaways

• The S&P 500 Index is going into the week of April 6 down 27% from the high and up 14% from the low set on March 23.
• At this point it is anyone's guess whether significant new price lows are in store for us in the coming months. There may be more bad news in terms of health outcomes, job losses, and earnings.
• Potentially mitigating further volatility, the US stock market has already priced in a lot of bad news. The US economy has also received unprecedented fiscal and monetary stimulus quickly.

In my view, the stock market has likely entered a holding pattern or consolidation of sorts, which would be fairly typical after the "crashing phase" of the bear market. During the crash phase, pretty much everything other than cash and Treasurys gets liquidated in a wave of indiscriminate, and often forced, selling as investors re-reprice assets for a new reality and leveraged players get margin calls.

Judging from the market's internals, such as the number of new highs minus lows, the percentage of stocks above or below their moving average, the number of standard deviations below trend, the dispersion of sector returns, and, of course, sentiment, we reached that selling crescendo on March 23. On that day, the S&P 500 index reached an intra-day low of 2,192, down 35% from the all-time high of 3,394 set on February 19.

Since then, the index has rallied exactly 20% into the month/quarter-end rebalance window, before predictably trading lower again last week. We start the new week at 2,489, down 27% from the high and up 14% from the low.

So far, the price action has been "textbook," as much as anything can be called that in the wake of the COVID-19 pandemic. But in terms of the tape, the crash phase has taken the market down 35% in only a few weeks, only to recover 20% from the lows, only to meet new selling at technical resistance (a 38% Fibonacci retracement from high to low).

2020 compared to 1987 and 2008

About the expert

Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.

The S&P 500 index, as well as the market's internals, have closely followed the charts during the crash of 1987, as well as the crashing phase of the Global Financial Crisis (GFC) in 2008. In both instances, from their respective trading lows on October 20, 1987, and October 10, 2008, the S&P 500 gained 20% in short order and then failed. From that point on, however, there was a big fork in the road and the 2 analogs diverged.

Following the crash in 1987, the bull market resumed 2 months later

In 1987, the market successfully retested the lows on December 4, and gradually regained the losses in the following months and quarters. It took almost 2 years to make new price highs, in August of 1989, in what was a slow but consistent resumption of the secular bull market of 1982–2000.

Following 2008, the bull market resumed in 2013

In 2008, on the other hand, the market was far from done in terms of the decline. After gaining 20% to 1,008, the S&P 500 fell another 27% to a new low of 741 on November 21, only to rally another 27% to 944. Following that rally the index fell another 29% to its final low of 667 in March 2009. It wasn't until 2013 when the index finally made a new high. That was the secular bear market of 2000–2013.

We don't know what will happen in 2020

At this point it is anyone's guess whether significant new price lows are in store for us in the coming weeks and months. It's unknowable in real time, but given that the index is less than 300 S&P points from the low, it can certainly not be ruled out.

On the one hand, we pretty much know that the news on both the health front as well as the economic and earnings front is bound to get worse before it gets better. With every headline of more coronavirus deaths, every report on jobless claims, and soon, earnings announcements (Q1 earnings season starts this week), investors will be tempted to sell.

But bad news has already been priced in and stimulus may help

But this increasingly negative news flow is at least in part mitigated by 2 things. First, a lot of bad news has already been priced in, with the stock market down 35% and credit spreads up to 351 basis points for investment grade and 1,034 basis points for high yield at the recent extreme.

Price often leads earnings, especially at major inflection points. During both the GFC and the dot-com bear market (2000–2002), price and valuation bottomed many weeks before earnings did. That's why (in my opinion) it's tricky to apply trough multiples to trough earnings when trying to calculate downside risk to prices. They often do not move at the same time.

Also, it's interesting to note that while investor sentiment has reached oversold extremes, corporate insiders seem to be taking the other side, as they often do at extremes. The ratio of insider sales to buys has now reached the levels seen at most major bottoms.

Second, only a few weeks into the crisis we have already had an unprecedented coordinated fiscal/monetary response (for a peacetime economy). During the financial crisis it took months for policy makers to do what this time has taken only a few weeks.

There may well be more relief/stimulus that is needed given the unprecedented shock to the economy, but at least the market has been put on notice that the policy response will be there if needed. For one, the Fed is showing us that it will do whatever it takes. Don't fight the Fed! Its balance sheet is infinitely bigger than yours.

Is this Modern Monetary Theory* in action?

For now I am assuming that the Fed balance sheet could potentially grow to $10 trillion. That's just a guess of course, but it has already grown from $4 trillion to $5.8 trillion in a matter of months, and the Treasury will be issuing trillions of new debt which the Fed will likely have to absorb.

It's interesting that during WWII, the Fed increased its balance sheet 10-fold as it monetized war debt and engaged in quantitative easing (QE) to enforce its price caps (around 2.5%). Given that we are now looking at wartime level deficits and again a Fed that will likely be monetizing those deficits, the parallel is not far-fetched. Modern Monetary Theory (MMT)* is here!

Will it be a V-shaped recovery?

As a result, in my view, this market cycle has entered the stage where it has transitioned from a one-way street to a balancing act. As the economic losses are now being reported and priced in, and with some health experts suggesting that the growth rate of COVID-19 cases may possibly crest in the coming few weeks, the big question going forward is what the shape of the recovery will be.

In terms of earnings estimates the market appears to be expecting a sharp V-shaped recovery. That may be too optimistic in my view, since it seems unlikely that everything will just go back to normal once social distancing starts to reverse. If social un-distancing happens in stages, then the V may look more like a swoosh.

Earnings estimates may be too optimistic

It will be interesting to hear what companies have to say during the earnings season that is about to start. My guess is that they will offer very little guidance about the upcoming quarters, which makes sense given that there isn't much of a playbook for this cycle.

While the earnings estimates have been marked down a lot already (with the Q2 growth estimate now at −16% and the 2020 estimate down to −6%), it doesn't seem to be enough compared to what the dividend futures are suggesting. The S&P 500 dividend futures contract (next 12 months) is pricing in a hit from $62/share to $40/share.

The market may have already priced in a hit to earnings estimates

That suggests a bigger earnings hit than what the street is pricing in so far. So get ready for a rocky earnings season. Having said that, when I overlay this against the drawdown in the S&P 500 and I balance the scales for the 2015–2016 earnings contraction, it still appears that the S&P 500 has more than priced in such a scenario.

Also, when I plug a $40 dividend value into my discounted cash flow (DCF) model, it spits out a fair value for the S&P 500 of 2,459. That is almost exactly where the index closed on Friday. Again, this gives me the sense that while health and economic news appears about to get even worse, the market is already ahead of the news.

For now, I continue to parse the price action and the market's internals for signs of exhaustion and selling fatigue. After 3-plus weeks being cooped up at home, the battle fatigue goes well beyond the markets.