As 2020 grinds on, the 2009 analog for the US stock market remains intact. The chart below shows the market bottom and subsequent recovery of the S&P 500 during the 2008/2009 Financial Crisis and aftermath (blue line) and the 2020 Covid Crisis still in process year-to-date (orange line). As with all stock market analog overlays, they are guides to the future until they are not. So, for now the recovery off of the 2009 bottom is providing an interesting comparison of what could be ahead, but in the markets, things are rarely this simple.
Are investors too optimistic?
As shown in the chart below, the Chicago Board Options Exchange (CBOE) Equity Put/Call Ratio has fallen to its lowest level in 20 years. The ratio is an indicator that shows put volume relative to call volume. Put options are used to hedge against market weakness or bet on a decline. Call options are used to hedge against market strength or bet on an advance. The Put/Call Ratio is above 1 when put volume exceeds call volume and below 1 when call volume exceeds put volume. Typically, this indicator is used to gauge market sentiment. Sentiment is deemed excessively bearish when the Put/Call Ratio is trading at relatively high levels and excessively bullish when at relatively low levels. Currently, the ratio of puts to calls is low (i.e. significantly more calls than puts), thus the inference is that investors have grown too complacent about risk and are no longer looking for downside protection. And by this one measure, they are now seeking the least downside protection in 20 years. This may reflect substantial confidence in the Federal Reserve, the recovery, a vaccine, or the next leg of stimulus. Or, perhaps a bit of hubris. Time will tell, but historically, this type of complacency has often been met with at least a pause (if not a reversal) in the stock market’s upward momentum.
Additionally, Morgan Stanley’s proprietary market timing indicator which considers fundamentals, risk and valuation metrics is generating its first sell signal in two years. See the chart below. When the dark blue line is above the light blue band, the indicator is flashing a warning.
The markets seeming optimism around a COVID vaccine and a swift end to the pandemic could be misplaced given that the majority (64%) of leaders in the healthcare industry, believe the pandemic will continue into the second half of 2021 or beyond. If the vaccine development takes substantially longer than the current rosy picture, markets may be impacted negatively.
The return of value?
For all of the handwringing and ink spilled over the death of value, it has kept pace with the more growth-oriented S&P 500 off of the bottom of this most recent crisis. See the chart below. It is again behaving, even with all of the flows into big tech, like it normally does out of a recession. With certainty around the recovery, it could potentially catch a spark.
In many ways, the last few years haven’t just been an issue with the underperformance of value, but rather the outperformance of a few large tech stocks – Facebook, Apple, Amazon, Microsoft, and Netflix (not listed in the chart below). These are some of the greatest companies ever created, but as we have written about in the recent past, we believe a game of catch up by the deadweight 495 ( the rest of the S&P 500 that have not mattered for years now), small-cap companies and international opportunities may now be at hand.
When complacency and exuberance dominate investor thinking, the markets have a tendency to shake investors from their peaceful state. While the odds of risk assets hitting the pause button in the near term have increased due to a number of metrics we follow, including those outlined above, the days in front of the election could provide an additional catalyst for volatility. While a bout of market turbulence could lie ahead, we think that the economy will continue to improve and that the environment for risk assets will remain favorable for some time as the tsunami of liquidity injected by the Fed and other central banks continues to slosh around the globe. And with any sustained strength, other still beaten down parts of the market have room to continue to move up.