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Risk Aversion and De-risking - Is this Temporary or Something More?

Risk aversion or de-risking is evident across the board today as Dow Jones Industrial Average (INDU) tumbled 943.24 points or -3.43%, the broader-based S&P 500 Index (SOX) plummeted 119.65 points or -3.53%, the technology-heavy NASDAQ Composite Index (COMPQ) plunged 426.48 points or -3.73%.


Wall Street and Main Street appear to be reacting to the harsh realities of the surging COVID-19 surging infections, the delay in the stimulus package, the potential for another global and domestic shutdowns, and now the risk of a contested presidential election. None of this should be surprising as healthcare experts have been warning for weeks and months of another spike in coronavirus infections into the winter months. Market pundits have also warned of the difficulties of the approval for the next stimulus package before election day. Political talking heads have expressed increasing concerns about a contested presidential election.


Although many of the above issues have been circulating for weeks and months, it appears traders and investors suddenly woke up this week and decided to sell first and ask questions second. It seems market participants were in denial and are now shocked by the realities of the recent developments.


From a technical perspective, the stock market consolidation began in earnest soon after a lower-high pattern developed in SPX as evidenced by the Oct 2020 high (3,588.11) lower than the Sep 2020 all-time high (3,549.85). The market sell-off was broad-based today as all 11 major S&P 500 sectors suffered declines of 2.22% to 4.24%. The sharp jump in the VIX index to 40.28 also warns of an increase in hedging activities and risk aversion. A large gap down today in SPX (3,388.71-3,342.48) further supports the broad-based selling of the S&P 500. Market breadth readings were decisively negative, and volume increased into the market close. The above technical conditions now suggest a retest of the Sep 2020 reaction low (3,209.45) and below this to the crucial 200-day ma (3,129.60). Under strong selling, SPX can even fall to the 38.2% retracement (3,055) from the Mar-Sep 2020 rally.


Unlike the past several weeks, the favorable S&P 500 sector rotations quickly reversed direction this week. The economically sensitive sectors and stocks that have kept the market trending higher dramatically turned downward. The S&P 500 sector rotations, if they continued, may signal a change in market direction.


A brief review of the RRG study of the 11 S&P 500 sectors now shows investors favoring defensive sectors (i.e., Consumer Staples (XLP), Utilities (XLU), and Real Estate (XLRE)). The Healthcare (XLV), another defensive related sector, is close to moving from the Lagging Quadrant toward the Improving Quadrant. Consumer Discretionary (XLY), a leadership sector, has recently slipped into the Weakening Quadrant suggesting the beginning of a corrective phase. The Basic Materials (XLB), a commodity and economically sensitive group, is also losing technical strength as it is close to slipping into the Weakening Quadrant. Technology (XLK) and Communication (XLC), two structural growth sectors, remain confined to the Weakening Quadrant implying further corrections.


In summary, the recent 10/12/20-present SPX correction has led to a 278.82-point decline or 7.85%. Another 71.58 points decline would put SPX at 3,209.45 or to the 9/24/20 low. The recent correction would then be on pace for a 9.59% decline, or just below the 10% threshold level. The test of crucial support will help to confirm a double bottom pattern (bullish) or a double top pattern (bearish). From a sector perspective, the emergence of the defensive related sectors this week hints at risk aversion or de-risking. Is this a temporary rotation, or is this the start of the wholesale flight to safety shift by investors?


Although the concerns of the spreading COVID-19 virus, the lack of a stimulus package, and a contested presidential election may explain the increase in market volatility, the fiscal calendar year-end is also around the corner on 10/31/20. Many money managers, mutual funds, hedge funds, and other institutions close their books at the end of the month. Window dressing and portfolio adjustments can collectively influence stocks, sectors, and markets, near-term. Will these market participants return to the marketplace next month ahead of the favorable seasonality period? The next few days or weeks will be critical as it will likely decide whether the correction is coming to an end or if this is the start of a deeper correction or even the next bear decline.


10/28/20 returns. Source: Courtesy of StockCharts.com

Quarter to date returns. Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com


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