Meeder Tactical Update: Perspectives on Recent Market Volatility
On February 19, the S&P 500 finished trading at 3,386, marking a new all-time high. Just six trading days later, on February 27, the S&P 500 closed 12.7% below this level, making it the fastest 10% or greater correction from an all-time high in the index’s history. Following the S&P 500’s rapid decline on Monday, March 9, it is now down nearly 19% from its all-time high. In addition, U.S. small-cap stocks, as represented by the Russell 2000 Index (RUT), have fallen nearly 22%. If it wasn’t clear by the end of February, it is certainly clear now; volatility has arrived.
The spread of the coronavirus has significantly impacted the stock market. Starting in China, the world’s second largest economy, the coronavirus has spread to other countries around the globe. While the economic impact of the virus is still unknown, uncertainty related to the potential economic impact concerns investors. For a closer look at the coronavirus and potential implications for the stock market, we encourage you to review a recent paper we released in late February titled “Coronavirus: What Does This Mean for the Economy.”
The Fed’s Response
In addition to the stock market decline, interest rates have fallen dramatically. For example, the 10-year and 30-year U.S. Treasury rates are now at all-time lows; both yielding under 1%. In response to the recent market volatility and uncertainty surrounding the spread of the coronavirus, the Federal Reserve slashed short-term interest rates by 0.50% on March 3. Between Fed meetings, this was the first emergency rate cut since 2008, and it also marks the biggest single cut since then. Based on the Chicago Mercantile Exchange’s Fed Watch Tool, the market is expecting additional rate cuts at the March Fed meeting.
Oil Prices Shock the Stock Markets
Late last week, OPEC, which includes Saudi Arabia and Russia, failed to agree on production cuts. The discussion was aimed at combatting the fall of oil prices, which had already plummeted more than 30% year-to-date on fears of slowing growth related to the spread of the coronavirus.
Early Sunday, Brent crude oil futures dropped an additional 30%, which was the largest drop since the Gulf War in 1991. The drop came after Saudi Arabia announced a sudden discount in oil prices to its customers in Asia, the United States and Europe. Saudi Arabia, the world’s second largest producer said it will increase oil production instead of cutting it. With no deal reached in OPEC, there is now fear that there will be a price war that could send prices even lower.
Tactical Model Positioning
Our tactical exposure is based on a combination of risk vs. reward. The reward value of the stock market is determined by the Meeder Investment Positioning System (IPS) which ranks over 70 factors. The IPS has three different components; our long-term, intermediate-term, and short-term models. The reward value is then compared to market risk, our measure of expected stock market volatility.
Our partially defensive position primarily stems from a weakening of short-term trends and the significant increase in volatility. Historically, many of the largest drawdowns in history were preceded by an increase in volatility. All else equal, we prefer to be more invested when market volatility is low. In stark contrast, volatility is well above its long-term average now.
The reward component of our model has actually improved since the February 19 peak. One of the primary reasons for this improvement is the high level of investor pessimism. For example, investment newsletters are displaying significant fear and option activity is showing extreme levels of panic from hedgers and speculators. As a reminder, we view this type of pessimism from a contrarian point of view.
While it is difficult to identify the actual day of a market bottom, we are observing certain characteristics that historically occur during market turning points. For example, the ratio of declining securities volume relative to advancing securities volume on the New York Stock Exchange is displaying panic selling. On three days last week, we observed three different ratios above 8:1 and on March 9 an extraordinarily high ratio of 28:1. This type of bearish selling is typically something we observe during market capitulation.
Another sign of capitulation that we are closely monitoring is correlation among equities. During normal market environments, the performance of individual stocks, industries, and sectors varies based on the expectations of investors. During periods of exhaustive selling, investors tend to “throw in the towel” and correlations increase dramatically. This is often a sign that a turning point in the market has developed.
Within the Intermediate-term model, we also track the expectations of Federal Reserve policy. Historically, an accommodative Fed that is cutting rates has been positive for future equity returns. The recent Fed activity and change in interest rate expectations has been one reason for the reward value remaining relatively positive.
Fixed Income Positioning
Within several of our tactical funds and portfolios, there is a fixed income allocation. During this drawdown, both our high yield and emerging market fixed income models switched to a risk-off position. As a result, we have significantly reduced our high yield and emerging market fixed income exposure.
At Meeder, we are dedicated to keeping clients committed to their investment strategy through a full market cycle. To achieve this objective, our tactical funds and portfolios aim to reduce equity exposure when market risk is high and increase equity exposure when market risk is low. We believe our systematic approach, based on the highest probability outcomes, will generate a better risk-adjusted return over a full market cycle.