There is little question that the stock market is wildly oversold. My intermediate term bottom spotting model has been flashing a buy signal for over a week. This signal is based on the combination of an oversold signal on the Zweig Breadth Thrust Indicators, and the NYSE McClellan Summation Index (NYSI) turning negative. In the past, this model has shown an uncanny ability to spot an intermediate bottom, but stock prices have continued to fall despite the buy signal.
Where’s the bottom?
Insiders are buying
There are a number of constructive signs that equities are starting to look interesting from a fundamental perspective. The most important of which is the appearance of an insider buying cluster (via Open Insider).
I would warn, however, that insider buying is an inexact fundamental signal. A study of past insider buying signals since the data set began in 2004 tells the story. Consider, as an example, how this group of “smart investors” behaved in 2008. They began buying heavily as the market skidded in October 2008, but the ultimate low did not occur until March 2009, when prices were 30-35% lower than when they began buying.
Insiders were more timely buyers in 2011, when the market convulsed over the prospect of the combination of a budget impasse in Washington, and the prospect of the breakup of the eurozone over the Greek Crisis. The 2011 episode was marked by a buy signal that coincided with a period of low downside risk.
Insiders were early to buy into the initial decline in 2018. To be sure, they bought heavily in a second cluster as the market reached the Christmas Eve bottom.
This brief study shows concentrated insider buying can be a useful signal for long-term oriented investors to start edging into stocks. However, this group of “smart investors” seem to focus mainly on valuation, and they behave like the classic value investor, who tends to be early in their investment decisions.
The S&P 500 peaked in January at an astounding forward P/E ratio of 19.0, but index has deflated considerably since then. Are stock prices cheap enough to be buying?
It depends on how you define cheap. The Leuthold Group analyzed valuations o n several metrics using two lookback periods. They considered historical valuation from 1990 to present, and 1957 to present. They found that the market is undervalued based on the 1990-2020 time frame, but overvalued on the 1957-2020 time frame. I interpret this analysis as the market nearing fair value, with the caveat that markets tend to overshoot to the downside in a bear market.
How far can it overshoot? Josh Brown highlighted analysis by BAML’s Savita Subramanian:
PEs are pretty useless: wide range At prior bear market troughs, trailing Price to Earnings (PE) multiples have ranged from 11x to 18x (today’s is 15x) and forward (NTM consensus) PE multiples have ranged from 10x to 15x (today’s is 16x). But historically, the market has troughed at an average PE multiple of 13x to 14x actual trough earnings, a posteriori. Applying this to our recently introduced 2020 recession EPS forecast of $138 yields a floor (worst case scenario) on the S&P 500 of 1800. But note that this is a much lower outcome than applying the typical peak-to-trough bear market decline of ~35% to February’s S&P 500 peak of 3393, which would yield a floor of 2200 (still below today’s levels). Our year-end 2020 target for the S&P 500 remains 3100.
Brown concluded that the estimated range of 1800-2200 is extremely wide.
Savita notes that if we go by the typical bear market decline of 35% peak to trough, then 2200 makes sense. If we go by Merrill’s new S&P 500 recession earnings forecast, and apply a PE at the midpoint of the above mentioned range, we’re talking more like 1800.
Regular readers will recall that I have a ballpark estimate of 1600-2160. This range was based on reducing peak forward 12-month EPS estimates by -10% (which is consistent with the 1982 and 1990 recessionary experience), and applying a 10 P/E multiple (2011 bottom) and 13.5 multiple (2018 bottom) to forward EPS.
My range of 1600-2160 is even wider than BAML’s 1800-2200. Since no one knows the level, depth, or length of disruption COVID-19 will impose on the economy, investors will have to live with the wide range until we can see a greater level of certainty.
To illustrate my point, FiveThirtyEight surveyed a number of infectious disease experts about the likely effects of the COVID-19 epidemic in America.
Collecting responses in this form captures both the best-guess estimate from each respondent and the uncertainty surrounding it. It also lets the people in charge of the survey — Thomas McAndrew and Nicholas Reich, both biostatisticians at the University of Massachusetts, Amherst — convert the responses to a probabilistic consensus forecast,1 something that can answer questions like, “According to these researchers, what is the probability that we will have 50,000 reported cases by March 29?”
Expert consensus forecasts give you what a model does — a forecast that gives a measure of its uncertainty — without being overly reliant on just one way of thinking about a problem. In this instance, each expert has their own assumptions about how likely the virus is to spread or to be fatal, as well as assumptions about the ways humans might try to mitigate its damage
The estimates vary wildly, and so are the ranges of each expert’s estimates. In other words, everyone is only guessing.
If the healthcare experts don’t know anything, how can the rest of us possibly hope to estimate the economic effects?
Technical analysis: More downside?
From a technical analysis perspective, I see more downside for stock prices before a long-term bottom can be seen. The market’s weekly Percent Price Oscillator (PPO) reached -3 last week. This extreme level was seen at the 2011 Greek Crisis bottom, and the 2018 Christmas Eve panic bottom, but PPO never even reach this level during the Russia Crisis. That said, sub -3 PPO readings were seen during the post-NASDAQ Bubble bear market, and the 2008 market crash.
The moral of this story is that sub -3 PPOs mark panic bottoms during corrections in bull markets, but may only mark the start of a decline in bear markets. As we are in the middle of a recession induced bear market, there may be further downside in the future. As well, the above chart shows that the index is now testing the first Fibonacci retracement support level. Additional support can be found at the 50% retracement level of 2000, and 61.8% retracement of about 1670.
That said, short-term indicators are off-the-charts oversold, and a relief bear market rally can occur at any time. I recently reviewed a series of past bear market bottoms, starting from the Crash of 1929, and found that the stock market generally either came back down to retest the initial bottom, or formed a complex W-shaped bottom. The retest may not always be successful (see 2020 bounce = 1987, or 1929?).
In summary, it is difficult to know when and where this bear market will bottom. My review of fundamental and technical factors comes to two conclusions. While the market can bounce and stage a bear market rally at any time, the historical record indicates it will return to retest the previous low, and the retest may not be successful. Until we can estimate the full extent of the damage caused by the pandemic, it is also difficult to estimate a level the market is likely to bottom. Estimates based on top-down fundamental estimates and technical analysis range from a 1600 to 2160.
Be prepared for further downside risk, and for longer than the consensus expectation of a V-shaped recovery. As Ryan Detrick of LPL Financial has shown, recessionary bear markets last for an average of 18 months, compared to 7 months for non-recessionary bears.