When it comes to stocks, should you advance or retreat?
Things got gloomy for investors for a while. Between Feb. 19 and March 23, stocks in Standard & Poor’s 500-stock index took a Wile E. Coyote-style plunge, losing 33.8% in just a month.
Despite uncertainty about the length and severity of the pandemic-related shutdowns that triggered the sell-off, investors, like the coyote himself, once again grew optimistic, pushing the S&P 500 back up — although not to its old high.
Lately, the market’s behemoths — Alphabet, Amazon, Apple, Facebook and Microsoft — have been leading the rebound.
“It’s OK for leaders to lead. But if the market’s generals are headed in one direction and the troops in another, then you have potential problems,” says Willie Delwiche, a strategist at investment firm Baird.
The generals-versus-troops metaphor is a common way of understanding an indicator known as market breadth, a measure of how many stocks are participating in a given market move. For investors practicing technical analysis (forecasting the direction of stock prices based on statistical patterns), understanding breadth is key to determining whether a rally in the stock market will lead to a sustained recovery or is masking further bouts of turbulence and downturns.
Wall Street traditionalists favor stock analysis based on fundamentals such as corporate earnings and business models. Fundamentals easily explain the precipitous drop in share prices in the wake of the COVID-19 outbreak, as government-mandated shutdowns slashed entire industries’ revenue streams to near-zero overnight.
Assessing subsequent rallies, such as the one that began in March, is trickier. Clearly, such spikes represent a bet that the global economy and corporate earnings will return to growth when the pandemic’s effects on the economy subside. But absent a vaccine or widely available testing, the timeline for successfully reopening the economy remains nebulous. Moreover, economists differ on what sort of recovery we’ll see, and many companies have rescinded guidance on the health of their businesses.
That’s when assessing patterns in investor behavior becomes an important tool. From the technician’s perspective, recoveries from bear markets come in four stages, says Reed Murphy, chief investment officer at Calamos Wealth Management. First, the market becomes oversold. Check. Second, there’s a rally. Check-plus: The 31% bounce back to the recent high on April 29 is among the biggest rebounds of all time. That bodes well for stage three, when the market retreats again, “retesting” its recent low. Rebounds as large as the recent one are seldom followed by big downturns, Murphy says. So far, the market’s pullbacks have been modest, although a bigger correction isn’t out of the question.
The final stage in a recovery is a sustained rally, with stocks firmly established in bull territory. It remains to be seen whether the gains from the market bottom means the beginning of a bull or a prelude to a return to lows.