Green Shoots

The bear case for the global economy is well understood and well-articulated. Below we outline arguments that make the case for recovery. The argument is built on a series of observations.

• In mid-March European equity markets saw measurable extreme panic and capitulation. On prior occasions this level of fear has been associated with above average forward returns.
• Relative valuations between cyclicals and defensives are at record dispersions, as is value compared to growth. From a relative valuation point of view, pessimism is at an extreme.
• In April European and global equities gave a rare positive momentum signal, also associated with above average forward returns.
• New cases of the virus are declining in Europe and economic re-openings are tentatively beginning.
• New treatment and vaccine development may beat pessimistic expectations.
• Central bank support is vast and growing.
• Fiscal expansion is unprecedented in the post war period.

Panic Signals

The VDAX is Europe’s VIX, aka the fear gauge, measuring expected volatility. On March 16th the VDAX had the highest one day reading in history. Below we show the Dax Index from 1992-2020 mapped with the 10-day moving average of the VDAX below it over the same period.

There have only been four occasions since 1992 where the VDAX 10 day rolling average has exceeded 50: 1998 when LTCM collapsed, late 2002-early 2003, late 2008 and March 2020. These signals have sometimes been coincident with a market low, sometimes a few months early. In all prior instances, investors have been rewarded for buying soon after.

Capitulation signals

Below we assess two measures that can be used to illustrate sustained, fierce selling pressure. The first is the number of stocks within an index trading above their respective 200 day moving average. The second is the number of stocks trading at 52-week lows. Both are measured daily. The equity index we are using for this data is the Stoxx Europe 600, a diverse pan-European equity benchmark. The dates go back as far as data is available – to 2002.

Over the last 18 years there have only been 4 instances where less than 10% of stocks in the Stoxx 600 have traded above their 200 DMA: late 2002 to early 2003, late 2008, August 2011, and March 2020. On March 16th this year just 3% of European stocks traded above their 200 DMA. We have only had a lower reading once before, with a 2% reading in late October 2008.

The second indicator, measuring the number of stocks at 52-week lows, saw a record reading on March 16th. 80.2% of the Stoxx 600 trading at 52-week lows on that single day. During the height of the post Lehman melt down the highest reading reached was 76%.

Like the VDAX rolling average, these readings are sometimes coincident with market lows, sometimes a few months early. In early 2009 indices made new lows, but this occurred with fewer stocks making new lows than in late 2008. Many stocks turned up before the benchmark.

Valuation extreme

The premium for growth over value in Europe is at a record. Today growth stocks are perceived to be more immune from the economic cycle, while value stocks tend to be more cyclical. The premium for this defensiveness in price to book terms is 280% and in price to sales terms is 220%.

It is worth noting that fear over the economic cycle began in late 2017 and this fear has intensified over the last two years. This likely gives cyclicals a higher margin of safety than during other recessions. It may also explain some of the resilience within equities overall.

Momentum signal

European, US and Korean equities have recently given a bullish momentum signal. These signals have been associated with significant market advances in the past.

We show the Stoxx 600 Equity index and below that, the percentage of constituents that trade above their respective 20 day moving averages (DMA) measured daily. We are only interested in high readings and so the scale is adjusted accordingly. On Thursday 9th April European equities had the highest reading on record with 95.7% of the Stoxx 600 trading above their respective 20 day moving average. Prior to this there have only been 6 trading days since 2002 with a reading above 93%.

As can be seen on the chart, in the past, these high readings confirmed market turning points. High readings are a sign of market breadth and therefore have been associated with market strength.

The S&P 500 and the Korean Kospi Index also registered record breadth readings on Thursday. This global show of strength is rare. Marrying these readings with the scale of oversold readings registered on March 16th helps lift the probability of a lasting market advance.

Case declines and the beginnings of economic re-openings

Italy, Spain, France and Germany have seen daily cases decline. Whilst the daily readings are volatile, new cases are between 30-50% lower than two weeks ago. Lock downs work. Some countries like Austria, Norway and Italy are looking to start partial re-openings of their economies in the coming weeks. Whilst the pace of the recovery is unclear, the macro low for the European economy is likely in April. Below we show the record decline and then recovery of the Chinese PMI, with the European PMI alongside. For now, markets are focussed on the rate of change. This bodes well for European markets as we move through May-June.

Treatment and Vaccine

Early data on Gilead’s Remdesivir is beginning to emerge and the news appears promising.

https://www.nejm.org/doi/full/10.1056/NEJMoa2007016?query=featured_coronavirus

The UK and China are becoming more confident that a vaccine may emerge earlier than some had considered. Instead of taking 18 months, there is a chance that a vaccine may emerge as early as this September. In addition to Professor Gilbert’s Oxford initiative, the PLA Chinese Academy of Military Science and CanSino Biologics are about to start phase II clinical trials with their own vaccine.

https://www1.hkexnews.hk/listedco/listconews/sehk/2020/0409/2020040900342.pdf

Central bank liquidity

The ECB and Federal Reserve balance sheets have expanded by over 2 trillion dollars in the last 3 weeks. This vast rise in the monetary base is not finished and is a significant support to asset prices.

Fiscal policy

The fiscal expansion announced to date is without precedent in peacetime.

Summary

Whilst predicting the path of this crisis is difficult, there are clear green shoots. The bear case is well understood and well advocated. But given sentiment, momentum, valuations and liquidity, upside risks must be considered.

• European equities exhibited extreme fear and capitulation on March 16th, with relative valuations at records. Since these capitulation signals we have seen bullish momentum in Europe, the US and Korea. Extreme capitulation followed by strong positive momentum has been associated with significant market advances in the past.
• The news flow on the spread of the virus is improving across Europe, with daily cases slowing. Given economic re-openings, the European macro trough is likely April.
• There are rising hopes that new treatment and vaccine development may arrive earlier than discounted.
• The support from central banks and fiscal policy is without precedent in any prior economic period.

Sources:
Lightman, Bloomberg, Strategas April 2020