Rebound likely, but cracks remain
The word ‘shocking’ does not begin to describe the reaction from seasoned market participants witnessing the onset of risk aversion decimating stock market conditions globally. After all, the CBOE Volatility Index has reached in a matter of days the same levels reached in the space of months during the onslaught of the Global Financial Crisis in 2008.
As far as contrarian indicators are concerned this one points to as close a condition as we will ever get to the ideal buying opportunity of the proverbial ‘buy low sell high’ mantra.
However, reality is not so simple and there are other indicators that bear watching.
We continue to track flow of funds data, which shows underlying risk aversion - net outflows from equity funds and net inflows into taxable bonds. This was an ongoing trend well before the coronavirus.
However, we find that spikes of risk aversion typically fail to sustain long-term outperformance on the part of Treasuries. Therefore, we believe the potential for a recovery in equities ought not to be ignored.
Underneath the surface, market rotation could occur with new sector leadership. Flows within the equity market are leaning more towards defensives and energy.
Will a rebound be sustainable? Our work shows that cracks still remain, particularly in the credit market. Financial conditions are tightening, high-yield spreads are only back near 2016 levels, and stress remains in the riskiest corporate debt tranches (CLOs).
Finally, our technical work from Dantes Outlook suggests following the path of least resistance and highest safety with credit worthy sovereigns.
Similar to previous virus outbreaks, we use key technical levels for dialing back risk and continue to assess market conditions as we update clients. For now, retracement levels and a variety of contrarian indicators will be used to monitor weekly market conditions as we update clients with our asset allocation views.
Please download our PDF report for details.