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Retest The March Low Or Not

 April 27 2020     David Templeton
The economic and equity market environment investors find themselves operating in today are different and more challenging than any environment they have likely faced in their lifetime. The steep market contraction from the February high was swift, i.e., declining 33.9% over a short 22 trading days, the fastest on record. With a nearly global economic shutdown due to mandatory stay at home orders, the economic growth rate, or should I write, contraction, is turning out to be severe. The CBO's estimate of U.S. second quarter GDP is for a contraction of nearly 40% at an annual rate. Over 26 million jobs have been lost in five short weeks, wiping out the job gains that were generated following the financial crisis of 2008/2009. So in the face of this poor economic data, will the equity market retest the March 23 low?

In Justin Mamis' book, Nature of Risk, he discusses his view of the equity market's sentiment cycle as it advances and pulls back during its longer term trend higher. The book included the following chart showing the different phases of the cycle.


The current market (S&P 500 Index) matched up with Mamis' sentiment cycle phases may look like the below chart. If Mamis' depiction of the cycle plays out, a lower low or retest of the March 23 low might be in the cards. I am not so sure this lower low scenario plays out though and touch on this below.


Some commentary has discussed the fact the current rebound off of the March low has been narrow. Additionally, comments have highlighted the fact the largest market cap companies in the S&P 500 Index are becoming a larger weight in the index than the concentration at the height of the technology bubble, which is true. However, when one looks at the return of the FAANG stocks (all but Netflix in the top 5 of market cap) since the March 23 low, they have underperformed the broader S&P 500 Index. In fact the FAANG's have underperformed the Invesco S&P 500 Equal Weight Index (RSP) by over 300 basis points. Further, the equal weighted S&P 500 Index has outperformed the cap-weighted S&P 500 Index. So on this front the market's recovery from the March low has been broader based within the large cap universe which is a positive.


Additionally, some have noted the low level of stocks trading above their 200 day moving average as another sign of a weak rebound. In this case though, as a rebound from a steep or waterfall decline gets underway it is only normal for the move to the 200 day moving average to take time. Below is a chart comparing the financial crisis recovery to the current one, and also includes the late 2011 selloff. Currently, the percentage of stocks trading above their 200 day moving average is about 15%. These prior instances, with the same percentage in the rebound as today, were associated with a market that continued to move higher.


And finally, Ed Clissold of Ned Davis Research included a string of five tweets on twitter that noted strong rebounds from steep or so-called waterfall declines are associated with milder retests. His analysis was based on the performance of the Dow Jones Industrial Average, but his comments are a worthwhile read. One chart in the series is below and shows that mild retests occur when the retracement rally's return is greater than the median return of all retracement rallies.


In conclusion, the current environment is so different from past economic slow periods. The current economic weakness is not the result of over supply that needs to be worked off. The economy was onĀ  a fairly strong footing before the virus related shutdowns. As the country and world begin to reopen, a strong snap back in activity is certainly probable. However, all segments of the economy are not likely to experience the same strong recovery. For example, I suspect travel related industries are more of a "U-shaped" recovery. As I read so often, the economy is backward looking and the stock market is forward looking, so recent strong equity returns just might be telegraphing a stronger than anticipated recovery. If that is the case, all that cash on the sidelines, $4.6 trillion, may need to find a home and stocks may be a beneficiary and the cash may provide some downside support for the equity market.