By Clint Sorenson, Chief Investment Officer for Sound Financial
Chart 1: S&P 500
Chart 2: VIX Volatility Index
There has been a meaningful change in the market as we have shifted from the low volatility regime we have enjoyed over the last several years. Volatility came back with a vengeance as the major market indices tested their long-term trends in February. The major market indices successfully held their long-term trends with most indices holding their 100 and 200 day moving averages. The S&P 500 index actually briefly bounced off the 200 day moving average and staged an impressive subsequent rally (see our report titled “Date with the 200 Day”).
The rally on the successful test of the long-term trend quickly covered a lot of ground as many of the indices went up over 6 percent from their lows. Most major indices, except for the Nasdaq, failed to reach new highs. This failed rally has now set up a move back down to test the long-term trend. The S&P 500 actually closed last week on the 200 day moving average. The Dow Jones Industrial Average, the FTSE All World EX-US, and the NYSE Composite have all broken to new lows. The NYSE Composite actually closed below the 200 day moving average, violating the long-term trend.
Chart 3: Dow Jones Industrial Average
Chart 4: FTSE All World EX-US
Chart 5: NYSE Composite
Chart 6: Nasdaq Composite
There has been an interesting breakdown within market internals over the course of the failed rally and subsequent re-test of the long-term trend. We believe this shift in risk-taking preferences by market participants is setting up for further downside—the most concerning of which is the widening in credit spreads and flight to safety we have witnessed in the fixed income markets. During the first decline, the market was mostly responding to a volatility spike that caused several funds to close and traders to unwind their positions. The US 10-year Treasury yield actually went up during this period suggesting that the preference for safety was not present, despite the sharp declines we witnessed in February.
Chart 7: High Yield Spreads
Credit spreads have now broken above their long-term moving average suggesting a potential change in trend. This shift, on its own, warrants considering a defensive posture due to the backdrop of a tightening federal reserve, increasing political risks (trade wars), and record high market valuations. Credit spreads are not the only measure of market internals that are deteriorating rapidly on the recent market decline. The percentage of stocks above their 200 day moving averages in the NYSE has also broken below the all-important 50 level. This breakdown is characteristic of a shift in risk preference as bull markets see this indicator stay above 50 and bear markets tend to see this indicator stay below 50. The current reading of 43 percent suggests most stocks in the NYSE have broken their long-term trends.
Chart 8: NYSE Stock Percentages Above the 200 Day
Market pundits are quick to point out that this recent decline was brought on by Facebook, trade wars, or political turmoil. The fact of the matter is that the narrative does not matter. Risk preferences among market participants are shifting and defensive positioning is warranted. The high market valuations, shifting volatility regime, and tightening Fed policy have set up for the potential of much steeper losses.
Chart 9: Facebook