Updated: Apr 3, 2020
As we end the first quarter of 2020 how bad was it?
It has been a historic and unprecedented quarter. The COVID-19 pandemic is one of the most severe pandemics in generations. As the pandemic spread across the globe this has led to dislocations in financial markets impacting currencies, commodities, fixed income and equities.
The insatiable demand for US dollars caused widespread disruptions in the global currency market. US Dollar touched its highest levels (103.96) in the past three years briefly exceeding its Jan 2017 highs (103.82). JPYUSD also benefited from the global risk aversion trade trading to a 4-year high of 0.9870.
WTI Crude Oil’s 66% plunged below $20 marking the worst quarter ever as this important commodity closed at 18-year lows. Gold was one of the few bright spots as it closed the quarter with gains of 4.83%.
Fixed income securities experienced extreme volatility, liquidity problems, and credit issues. The global flight to safety resulted in investors and traders all rushing into U.S. Treasuries as yields plummeted to all-time lows. In an unprecedented move, the short-end of U.S. maturities briefly touched negatives rates.
The meltdown in equities punished domestic and international investors and traders alike with one of the steepest first quarter drop in the Dow Jones Industrial Average’s 124-year history. For the quarter Dow declined -23.2% and recorded its worst quarterly loss since the fourth quarter of 1987. The larger and broader-based S&P 500 Index (SPX) also fell -20% for the quarter. This is one of the worst quarters for SPX. It hasn’t been down for three successive quarter since the fourth quarter 2008. NASDAQ Composite Index (COMPQ), a technology-heavy and growth-related benchmark, held up better than peers. Nonetheless, it also succumbed to the broad market sell-off declining -14.18% recording the worst quarter since the fourth quarter 2018.
Given the damages incurred over the past quarter what can we expect for the second quarter and the second half?
The following conditions will help to determine whether March 2020 low is indeed a major market bottom leading to a sustainable market recovery:
1. Implied volatilities are still too high. Key volatility indexes must fall further to calm the markets.
External/exogenous events such as pandemics are unpredictable and can take on different paths. It depends heavily on the extent of the spreading of the virus and the subsequent containment. These uncertainties often lead to widespread fear among investors and is reflected by the sharp jumps by implied volatility indexes such as VIX (SPX), VXN (NDX), and VXD (INDU). However, when the fear begins to subside this can lead to buyers more willing to return to the respective markets in question. Pay close attention to key technical levels in key volatility indexes. Trading below 36-40 can lead to VIX declining toward the low-to-mid 20s. A convincing decline below 37-41 can trigger VXN to return to the mid-20s. Violation of 30-34 would help bring about a decline in the VXD back to the low-20s.
2. Improvements noted in the credit markets but US Treasury yields still need to trend higher.
The severe conditions in the global credit markets may have subsided soon after a series of extraordinary Federal Reserve and central bank interventions. FED and central banks providing the backstop provided liquidity and calm the credit and fixed income markets. However, the 10-year US Treasury yields (TNX) as well as the 30-year Treasury yields (TYX) remain stubbornly low (yields). This hint of risk aversion and concerns of a US or a global recession and hence low interest rates. TNX must rise higher to at least above 1.00% and preferably above 1.25-1.40% to signal the start of a stabilization process in US treasuries. A convincing move above 1.75%-1.94% would also greatly help TYX return to a normal condition.
3. U.S. Dollar Index (USD) is still too strong.
The USD rises when there is global risk aversion and global liquidity concerns. USD must not breakout above 103.82-103.96 (2017/2020 highs) as this warns of widespread fears. Below 98 would help to stabilize the global financial markets and signal a return to a more normal environment.
4. Market internals such as market breadth needs to expand further.
Advancing issues minus declining issues or market breadth needs to broaden to signal a major market bottom. Although some improvements are noted over the near-term in the market breadth readings of a few US stock indexes these trends must expand to encompass other market indexes.
5. Leadership sectors must emerge over the next quarter and sustain into second half of the year to entice long-term investors to return to the marketplace with conviction.
This has been a historic quarter for equities as evidenced by the broad global equity market selloff. Amidst the recent 35% SPX melt-down, we were pleasantly surprised by the relative strengths coming from several S&P sectors including Technology (XLK), Healthcare (XLV), Consumer Staples (XLP), Utilities (XLU), Communication Services (XLC), and Real Estate (XLRE). It is reasonable to expect defensive sectors (XLP, XLU, and XLRE) to perform well during periods of market uncertainties and turmoil.
However, to confirm a major market bottom and to sustain an intermediate-term to longer-term equities recovery investors must buy and not trade the markets. Long-term investors must be both the catalyst and the primary driver of the rally. That is, conviction buying must come from strong hands. Remember, long-term investors must believe in a sustainable story, an attractive strategy, and/or solid investment theme to buy with conviction.
It is also interesting to note that the two best S&P 500 performing sectors (Technology and Healthcare) for the past quarter are two long-term secular growth stories. Not only are these two S&P sectors the largest market cap weighted sectors in the SPX Index the strong relative strength readings show that there are underlining long-term investors actively involved in these markets. After all, long-term investors buying with conviction are needed to sustain a long-term bull market rally.