US Strategy Weekly: What We Are Watching

Stats and Treasuries
There will be a lot of news impacting the equity market in the coming months including economic data that could become quite ugly. But if we had to choose only two bits of data to watch in order to measure the risk/reward of the equity market, it would be the daily statistics on the virus in the US (looking for a peak in both new cases as well as deaths) and the 10-year Treasury bond yield. To a large extent we believe the debt market will be the best guide for equity investors in coming months. The 10-year US Treasury bond is valuable because it is a global market instrument, and as such, it incorporates information regarding global economies, politics, sentiment and liquidity. Since many investors view the US Treasury bond as a safe haven investment, it may be the best sentiment indicator to monitor in 2020. If this is true, it is possible that the March 9 record low of $4.99 in the 10-year Treasury yield index (TNX – $9.97) represented a peak in global panic; and if so, it is also possible that this panic low marked the beginning of a bottoming process for many financial markets.

Fundamentals are Fuzzy
Still, there are many things we are monitoring and perhaps the most challenging is assessing fundamentals. It will be months before we have data on first and second quarter GDP. But in mid-April first quarter earnings season will begin and the corporate guidance that accompanies these reports will give us our first clues as to how corporate America will be impacted by the COVID-19 crisis.

We can expect that it will generally be bad news and earnings estimates will come down. But keep in mind that many segments of the economy are doing well. Healthcare, pharmaceuticals, personal care products, communication services, utilities, e-commerce, delivery services, and videoconferencing will be among the industries that will be beneficiaries of the current situation. Yet many companies will be hurt, and one can expect shakeouts in some sectors such as energy and retail. In the interim, we can try to measure the risk in the overall market by assuming there will be an earnings recession in 2020. Therefore, it is reasonable and prudent to look at the risk in the equity market if earnings decline 10%.

Based upon the current level of inflation and the benign interest rate backdrop our valuation model suggests an average PE of 17.2 X is appropriate for both this year and 2021. S&P Dow Jones estimates earnings were $157.10 in 2019 which means a decline of 10% would suggest earnings of $141.39 in 2020. Applying a PE of 17.2 to $141.39 translates into a fair value target of SPX 2430 for 2020. As seen in our valuation model on page 3 and the charts on page 6, the SPX has already traded below that level. Yet, if we take this one step further and project a second 10% earnings decline in 2021, SPX earnings fall to $127.25 and the mid-point of our forecasted trading range drops to SPX 2340 in 2021. We believe this is very unlikely, but it is a valuable exercise and it shows that the March 16 close of SPX 2381 came close to discounting a two-year earnings recession, or a 20% decline in earnings.

Another way of looking at a worst-case scenario for the market would be to use $141.39 earnings in 2020 and a long-term average PE ratio of 15.5 times. This lower PE multiple could apply if there were uncertainty regarding the longer-term prospects for earnings growth. Earnings of $141.39 and a PE of 15.5 X translates into downside risk to SPX 2191. All in all, these exercises indicate that fundamental factors point to a wide range of possibilities, but the SPX 2400 and SPX 2200 levels tend to be areas of fundamental support.

Technicals Worth Noting
In the last 17 trading sessions, there have been seven trading sessions where volume in declining stocks represented 90% or more of the day’s total volume. These days are classic examples of panic selling and three of these seven down days were Mondays, representing classic Panic Monday selling sprees.

History suggests that the worst of the selling pressure tends to be over once buyers come back to the market in earnest and this shift is represented by a 90% up day. Indeed, after the March 12 close of SPX 2480.64, a 93% up day materialized on March 13 (Friday). Nevertheless, this 93% up day was followed by another disastrous Monday decline in which 93% of the volume was in declining stocks, the advance/decline ratio was 1 to 15 and the daily new high/low ratio was 1 to 65 and the market fell to a new low of SPX 2386.13. Volume was only slightly above the 10-day average since circuit breakers interrupted trading twice during this session. These circuit breakers are one of the ways the current market structure differs from historical precedent. They make it more difficult to find that high-volume big-decline capitulation day that washes out the market and often defines a significant low. Nonetheless, there is no doubt that volatility is at record levels and as we showed last week, to date, March 2020 has been more volatile than any month during the Crash of 1929. This is amazing since that crash preceded the Great Depression, a global trade war, a broken banking system, and the Dust Bowl that joined forces in 1930. Things are far less dire today.

But when we look at current breadth data, we do find similarities to the 2011 low. The 2011 decline was precipitated by a well-anticipated downgrade of US sovereign debt on August 8, 2011 and it was linked to a belief that a recession was at hand. The choppy August to October 2011 period was characterized by a confusing pattern of alternating 90% down and up days; yet when we look closely at that period we find that the first 90% up day occurred on August 9, 2011 (see arrow on page 7). This up day followed the August 8 low of SPX 1119.46. Although the ultimate low for 2011 did not materialize until October 3, 2011 at SPX 1099.23, this lower low in October was merely 1.8% below the August 9 close. In sum, the first 90% up day did indeed indicate that the worst of the selling was over, and the bottoming process had begun. We believe this may also be true of today’s environment. While we expect much volatility in the weeks ahead, the March 12 low of SPX 2480.64 and the March 16 low of SPX 2386.13 (4% lower), is hopefully the beginning of a bottoming phase for equities. Note that the December 2018 low of 2351.10 — a significant support level — was also tested on March 16. When we look at the chart of the SPX, it is clear that the uptrends from the 2009 and 2016 lows have been broken. But the SPX chart also shows important support levels are found around SPX 2400 and SPX 2200. See page 6. Both of these levels coordinate well with the valuation benchmarks discussed earlier.

No Comparison to 2008
To date, the 29.5% drop seen in the SPX is greater than the long-term average decline of 24% and is the largest decline since 2008. See page 5. Although there may be reasons to compare the current marketplace to the 2008-2009 period, keep in mind that this is a medical crisis and not a liquidity crisis. Therefore, the recovery from this crisis should be much easier to accomplish once the virus subsides and/or a therapy and vaccine are in place. In 2009 earnings for the S&P 500 index went negative for the first time in history. To have the S&P 500 report a deficit for the year is far different from earnings declining by 10% or more. The SPX’s deficit in 2009 was due to massive profit losses in the banking sector. Today, after the virus peaks, the prospect for a rebound in earnings is substantial due in large part to a low unemployment rate and a strong banking system. It will not be simple, but the federal government has made it clear it plans to support small and medium sized companies and their employees during this unusual period. In short, the 2020 equity market is apt to provide investors with an excellent buying opportunity, but we expect prices will remain unpredictable and volatile for a long while.

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Never let emotions cloud your judgement … sound advice to Sonny from Don Vito Corleone.

DJIA: 21,201

Sound advice for markets like this as well, at least on an individual basis. When it comes to investors en masse, that’s different. There you want emotion, fear, even a little panic. Selling makes market lows, not buying. Stocks go up with relative ease once you get the sellers out of the way. And that usually takes bad news—news bad enough to turn complacent, ride-it-out holders to scared sellers. Certainly Monday, and then Thursday, had that look. It’s relatively rare to see 50% of stocks in an S&P sector all reach a 12-month new low. When it does happen, it’s typically a sign the sellers are exhausted. Monday saw 50% of the S&P make a 12-month low. Fewer than 2% of the S&P stocks were up on Monday and they accounted for only 3% of the total volume—another sign of exhaustion selling. That said, the only way to be reasonably sure the selling is exhausted is by the way they go up. They should go up almost as though a vacuum had been left on the upside.

So what does this “vacuum,” this absence of sellers, look like? After a “washout,” 18-to-1 down day in the A/Ds on Monday, it looks like a 5-to-1 upside A/D day at the minimum. That’s the simple rule, less simple is 90% volume days to the downside, of which we’ve had a few, followed by 80-90% volume days on the upside, where at 89% Tuesday, obviously seemed positive. We’re a bit dubious, however, that Tuesday’s up-volume number wasn’t somehow distorted. It seems very strange up stocks numbered only 2,900 versus 1,090 declining stocks, not even a 3-to-1 up ratio, and yet volume was so one-sided. In any event, the up-day you should be looking for is at least 5-to-1 in terms of the A/Ds, and 80-90% up in terms of volume. The other catch is that violent declines like this one more often than not require several such days.

We’ve all had drummed into us, the trend is your friend. What they really mean, of course, is an uptrend is your friend. Those downtrends are friends to few. In a market like this, the question naturally arises as to whether the trend remains up, in this case the long-term or overall trend. We have our proprietary, very sophisticated method of determining the overall trend, one involving very complex equipment—a pencil and a ruler. The long-term trend remains up. A slightly more sophisticated trend analysis was offered by Ned Davis several years ago. The study involved the 50-day moving average of the DJIA compared to the 200-day moving average. We haven’t seen an update of the study in a number of years, but for some 113 years, all the net gains in stock prices have come when the 50-day smoothing was above the 200-day smoothing. The DJIA 50-day (28,044) remains well above the DJIA 200-day (27,208). As you can see on the other side, that’s also the case for the S&P and NASDAQ 100.

There are 28% declines and there are three-week declines—there are not many 28%, three-week declines. Precedents are hard to come by, especially when it comes to Monday’s halt in trading. The only other time circuit breakers had been triggered was October 27, 1997. Once trading resumed on October 28, futures dove about 3% and then recovered. Obviously a sample size of one isn’t much help. looked at other times the S&P fell the most in the shortest amount of time, from at least a multi-year high, and even here the current plunge stands out. Others fell this much, but not as quickly. The closest comparison in time and magnitude was 1990, when the S&P fell 18% within 52 days of hitting a new high. Looking at returns going forward, by the time the S&P fell at least 18% within three weeks of a multi-year high, returns were good—the exception 1929

It’s like ’87 meets 9/11. Thursday markets suffered one of their worst declines ever. On the NYSE, 77% of issues traded hit a 52-week low. Everytime that figure has been above 60%, the S&P was higher one-to-two months later, according to On the NYSE, 95% of volume was in declining issues for the second consecutive day. That’s only happened three other times, each in the midst of a selling climax. Stocks look sold out, but you could have said that last week. Before the ’87 crash, we remember there being a high level of Put buying, making it unclear how so much was lost. The story told is that Put buyers turned to Call buyers half way down. Prices have become so compelling, it’s difficult to keep your fingers out of the cookie jar. When stocks finally are sold out, there will be a sharp rally. Just when you think you missed the low, there will be another move down—a “test of the low.” That’s the safest time to buy, unless you happen to enjoy those knife wounds.

Frank D. Gretz

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US Strategy Weekly: Wash Your Hands

Yesterday the World Health Organization declared the coronavirus to be a global pandemic. At 9 pm last night President Trump announced a 30-day travel ban with Europe. This combination suggests a recession might already be in place in Europe and this could easily hurt the US economy.

Last night I spoke to a doctor from the Mayo Clinic. She indicated that the hospital is expecting the spread of the virus to rise dramatically over the next two weeks. The reason for this is that coronavirus is a new virus, and no one has immunity. Statistically a normal person with the flu might infect 1.7 new people, but a coronavirus victim appears to infect 2.5 people. A coronavirus-infected person is symptom free for 3 to 5 days and is contagious during this time. While the normal flu virus can live on tabletops and other surfaces for two hours, the coronavirus can survive for two days or more. The reason some experts are suggesting staying six feet away from others (social distancing) is that the virus appears to infect an area three feet around someone with coronavirus. And finally, the fever that accompanies the coronavirus could reach 104 degrees and have symptoms of pneumonia in some cases. These are the factors that make it more deadly for the elderly and those with compromised immune systems.

She added that there is no need to panic and to a large extent this is much like a very bad flu; but in coming weeks and months it is important that everyone protect themselves by regularly washing their hands with plain soap and water for 20 seconds. The elderly and those with compromised immune systems should consider social distancing or perhaps self-quarantining.

Given what we know today, it is likely that the coronavirus epidemic will become much worse in the next two weeks. In the interim, we should expect the financial markets to remain under pressure.

The positive in the current situation is that this is a medical crisis and not a financial crisis. The 2008 crisis triggered systemic risk in the global banking systems. Had a liquidity crisis ensued it could have spiraled out of control. This is not true today; our financial system is well capitalized. In addition, President Trump has indicated that he will recommend to Congress that small and medium sized companies affected by the epidemic be offered credit during this period and employees suspended due to the crisis should continue to be paid. The US economy demonstrated good momentum up until the end of February and once this medical crisis is over it should spring back quickly. However, in the near term there are many unknowns. Financial markets handle bad news well, but they handle unknowns poorly.

In times of great uncertainty, we measure the worst-case scenario with trailing SPX operating earnings. Earlier this week we wrote: “If we measure downside risk using the average PE of 15.6 and SPX’s 2019 earnings of $158, we find a low-risk valuation target of SPX 2465. Note: this is 9.8% below this week’s intraday low of SPX 2734. Also supporting the equity market is the fact that the SPX dividend yield is now 152 basis points above the 10-year Treasury yield. This is the highest spread since March 1955.”

The bottom line is everyone should protect themselves and their families by being wise in terms of socializing and washing their hands frequently throughout the day with simple soap and water.

Regulation AC Analyst Certification
I, Gail Dudack, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is, or will be directly or indirectly related to the specific views contained in this report.

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“Overweight”: Overweight relative to S&P Index weighting
“Neutral”: Neutral relative to S&P Index weighting
“Underweight”: Underweight relative to S&P Index weighting

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