Stocks Will Fall Further Only If This Is A Recession

Big Tuesday Rebound

The stock market rebounded sharply on Tuesday as it was up 4.94%. This makes sense because it was very oversold on Monday. There was a point in the morning where stocks went negative, but by the afternoon, stocks gained momentum and rallied to the close. That’s been a theme with rallies in the past couple weeks. 

Investors woujld like to see calm rallies where markets don’t have large swings and increase less than 2%, but that’s not realistic. Either this is a bear market rally or this is the start of a new bull market. Both of those involve violent price swings. Bull markets start with big rallies and then trading becomes less extreme.

As you can see from the table below, in every single 5% or more S&P 500 drop on a Monday the next day had a big rally. Median rally was 4.65% and stocks were up 100% of the time. This was almost perfectly in line with the median. Now let’s look at the rest of the results. As you can see, the median gain in the next 6 months after the big decline is 14.71% with an 88.9% success rate. As long as this isn’t another financial crisis like 2008, stocks should be up significantly.

Details Of The Large Rally

It's not certain if this is the end of the bear run. But there are plenty of good values to be had and the majority of the selloff is likely over. If you believe the majority of the selloff isn’t over, you’re saying the total decline will be more than 28%. That's tough to believe because that would likely fully price in a mild recession which we don’t even know will happen yet. 

VIX fell 7.16 to 47.3, but it’s still extremely high. If markets normalize, we will be looking at a much lower VIX very shortly. CNN fear and greed index was a great buy signal as it fell to 3 on Monday. It rose 3 points to 6 on Tuesday. Markets are still very oversold. As you can see from the chart below, the put to call ratio is similar to where it was at the bottom in December 2018. In fact, I used this ratio to say stocks were overbought earlier this year. My, have things changed!

Nasdaq was up 4.95% and the Russell 2000 was up 2.85%. Considering how huge the decline in the small caps was on Monday, this was a very small rally. That doesn’t fully make sense because the long bond finally sold off. 10 year yield rose from 57 basis points to 81 basis points. It has since fallen 13 basis points in the evening session on Tuesday. 

30 year yield rose from 1.02% to 1.28%, but fell 12 basis points on Tuesday evening. Fed will very likely cut rates to 0% this year. CME Group website shows the Fed’s decision in 7 days will be a 75 basis point cut. There is a 69.4% of a 75 basis point cut and a 100% chance of at least a 50 basis point cut. Why not just go to 0% right away? We will see shortly.

Is This A Recession?

The bond market already priced in a recession at the trough. Even now, it is quite bearish. Fed is following the bond market by cutting rates quickly. This was a full cut cycle. It can’t get any fuller; all the hikes are about to be rescinded. The stock market isn’t fully pricing in a recession, but it’s getting there. Now, I’m not ready to call for a recession there's been no recessionary data! 

It's not good to call for recessions based on hot air. And, it’s not even 100% clear the Chinese economy will fall into a recession. China had 1 month of recessionary data. That doesn’t make it in a recession, although, it hasn’t been recovering quickly.

As you can see from the chart below, the Bloomberg calculation shows there is a 55% chance of a recession in the next year which is the highest of the cycle. Personally, I think it’s silly to worry about 1 year. Either there will be a recession in Q1 and Q2 or Q2 and Q3. If the coronavirus doesn’t cause recessionary data to come out by Q2, it will never come out. This likely won’t be as big of an issue in 2021.

The recessionary question is important because you should be buying stocks aggressively if you don’t think this is a recession. While you shouldn’t be optimistic about the near term if this is a mild recession. This decline should reach 20% if there isn’t a recession and 30% if there is a recession.

As you can see from the table below, the average decline for bear markets in recessions is 37% and the average decline of bear markets not in recessions is 24%. If there is a 55% chance of a recession, you can say the expected decline is 33.55%, but I’m more bullish than that. That’s because I think this will be a modest recession and the odds of a recession are a bit lower. If this recession causes only a 33% decline because it’s small and there is a 40% chance of one, the decline should be 22.8%. That’s reasonable.

Tax Cut Coming?

The market hadn’t known about Italy shutting down completely before trading on Tuesday because it was announced on Monday night. Yet stocks still rallied because they were oversold. The chart below shows if the government does a 2% payroll tax cut like Obama did in 2011 and 2012 and the Fed cuts rates 150 basis points, it would help GDP growth by 0.8%.

That wouldn’t be enough to fully counteract the 1.4% decline a high negative impact from the coronavirus would have. Good news is President Trump is trying to cut the payroll tax completely for the rest of the year. Markets will react to the likelihood of it getting done.

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1 Comment

  • Kevin Morgan

    March 11, 2020

    "the majority of the selloff is likely over".

    Perhaps so. At 20% or so to date, that leaves room for as much as an additional 19% (relative to the starting all time high), and it would still a correct statement, for a total of a 39% "correction" (bear market). But likely isn't certainly, and it could end up being well beyond -40% before it's over too.

    At the moment, in overnight futures, the 20% is now sitting at 23%, and /ES is falling like a rock.

    Once again, no it's not like 2009; this is not a "financial" crisis. It's an epidemic crisis. Vastly different. It's very hard to project the breadth and depth of impact. But cool headed experts say there's potential for as much as 1/2 (or more!) of humanity to get it. One might expect the economic impact of that to be rather severe, both directly and due to what happens as people and governments strive very hard to AVOID getting it. Seems to me the market is operating on somewhat well grounded "fear", that is, discounting the more and more likely major economic slowdown in the future as it always does. Glad I've got significant shorts on tonight! And VERY glad I convinced some key friends and family to exit this market over the last 2 weeks for exactly this reason.

    I also believe this is NO time to be starting to accumulate yet, as you suggested it might be. Far too much further downside risk. My $0.02. YMMV, I'm not a CTA, my comments are for educational and entertainment purposes only.

    Your analysis is always predicated on hard economic evidence. Very reasonable, and why I read your excellent work here. But this is a unique exogenous circumstance moving much faster than economic data! Your discounting it until the data arrives, to use an analogy, is a bit like saying "well, we know the asteroid has a pretty good chance of hitting the earth, but it might not and until it does and we see the results economy, it's not rational to price it in so heavily". Not a perfect analogy but perhaps it makes the point.