Near-term pullback, long-term uptrend

Why we could see a near-term pullback, followed by a resumption of the secular bull market in stocks.

On March 13, 2020, we began talking1 and writing2 about a series of tactical market bottom indicators3 that showed signs of extreme risk-off positioning, which were positive from a contrarian perspective. One of those indicators was the Chicago Board Options Exchange (CBOE) equity put/call ratio. Little did we know it at the time, but ten days later, the S&P 500 Index would put in what now appears to be a major low for the cycle.

What is the CBOE equity put/call ratio and why does it matter?

The put/call ratio is a measure of seller (put) relative to buyer (call) positioning derived from the options market, where a ratio greater than 1 signals more sellers than buyers (or extremely negative investor sentiment) and usually aligns with big market bottoms. On March 12, 2020, the put/call ratio hit 1.28, its highest level since 20084—in the depths of the Great Recession and Global Financial Crisis—meaning risk-off positioning was lopsided and investor pessimism was overwhelming.

The put/call ratio served us well three months ago, but what is it telling us now?

Unfortunately, there may be at least a temporary wrinkle in the bull case for stocks. The recent trough-to-peak surge of 44% on the S&P 500 Index compressed the put/call ratio to 0.37 on June 8, 2020, its lowest level since 2010—just before the peak of the European sovereign debt crisis. In other words, risk-on positioning has gotten stretched, and the bulls are running rampant, raising the likelihood of a near-term pullback in stocks akin to what we saw in 2018, 2015 and 2011.

Figure 1. Too many buyers, not enough sellers

Source: Bloomberg L.P., Invesco, 06/11/20. Notes: CBOE = Chicago Board Options Exchange. The CBOE Equity Put/Call Ratio is a measure of seller (put) relative to buyer (call) positioning derived from the options market, where a ratio less than 1 signals extremely positive investor sentiment. An investment cannot be made in an index. Past performance does not guarantee future results.

Beyond investor positioning, is there a broader bearish case to be made for stocks?

In our view, the bearish case includes 5 points of pessimism, namely:

1) Fears of a potentially deadly second wave of the coronavirus as the economy reopens and we approach cooler fall weather; 2) the risk of a negative feedback loop between stocks and 2Q20 gross domestic production (GDP) and earnings per share (EPS); 3) heightened US-China tensions; 4) overvaluation; and 5) tactical overbought conditions, as discussed. All valid points, any one of which could prove to be the catalyst for a near-term pullback in stocks.

Figure 2. The optimists always win in the end

Source: Invesco, 06/11/20. Notes: GDP = Gross domestic production. EPS = Earnings per share.

How does the bullish case stack up?

That said, we remain compelled by the breadth and scope of the bullish case, which includes the following 10 points of optimism:

1) Massive, unprecedented and coordinated monetary policy support; 2) similarly impressive fiscal policy support; 3) cautious investor positioning in the form of high cash balances and net short positions in stocks; 4) negative investor sentiment as expressed by persistent outflows from stocks and more bears than bulls in the individual investor survey; 5) a structural oversold condition as seen in the rolling 20-year total returns on stocks; 6) plateauing or flattening coronavirus daily cases overall; 7) a potential treatment for the disease that is being researched and developed by a host of companies around the world, and that has already moved to human trials; 8) a potential vaccine for the virus that is evolving similarly; 9) the high-frequency economic data like weekly initial claims for unemployment insurance are improving; and 10) the economy is reopening and activity is moving in the right direction, as evidenced by the daily mobility data.

Is this a cyclical bear market in a secular bull market, or is this a cyclical bull market in a secular bear market?

While it may seem like a daunting task, we believe it is possible to differentiate between secular bull and bear markets. It is said that the trend is your friend except at the end where it bends. Historically, secular bull markets have not ended until stocks have produced 20-year annualized total returns of 11% to 15%. In the current environment, however, 20-year returns remain muted, so much so in fact that they seem more consistent with a secular bull market in its earlier stages than one in its later stages.

Figure 3. The trend is your friend except at the end where it bends

Source: Bloomberg L.P., Invesco, 03/31/20. Notes: Rolling 20-year annualized returns on the S&P 500 Total Return Index, calculated using quarterly data. SE = Standard error. Dark gray areas denote secular bear markets in US stocks. Light gray areas denote secular bull markets in US stocks. An investment cannot be made directly in an index. Past performance does not guarantee future results.

Amidst the biggest economic event in modern history, we must admit to being surprised by the v-shaped stock market recovery and the fact that equities haven’t yet re-tested the March low. Based on some of the tactical breadth and positioning indicators that we monitor, however, there is a case to be made for a near-term pullback in stocks. Short-term volatility aside, we believe the long-term bull case (10 points of optimism) outweighs the bear case (5 points of pessimism). As such, we think investors may benefit from maintaining structural exposure to stocks in the years ahead.

Footnote

1 Source: BNN Bloomberg, Why this strategist sees long-term investment opportunities post-Covid 19 chaos, 03/13/20.

2 Source: Invesco, Chaos can create opportunities, 03/19/20.

3 Source: Invesco, Looking for signs of a bottom in stocks, 04/01/20.

4 Source: Bloomberg L.P. as of 5/31/2020

Important Information

Blog Header Image: Schira Kosmin Rudi / EyeEm/ Getty

Contrarian investing is an investment style in which investors purposefully go against prevailing market trends by selling when others are buying, and buying when most investors are selling.

A put option is an instrument that gives the holder the right to sell an asset, at a specified price, by a specified date to the writer of the put.

A call option is an instrument that gives the holder the right to buy an asset, at a specified price, by a specified date from the writer of the call.

GDP is the total value of all finished goods and services produced within the United States’ borders in a specific time period.

EPS are the total value of US corporate profits divided by the same companies’ common stock outstanding.

The SE is a statistical term that measures the accuracy with which a sample distribution represents a population by using standard deviation.

All investing involves risk, including risk of loss.

A decision as to whether, when and how to use options involves the exercise of skill and judgment and even a well conceived option transaction may be unsuccessful because of market behavior or unexpected events. The prices of options can be highly volatile and the use of options can lower total returns.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

The opinions referenced above are those of the authors as of June 12, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations. This does not constitute a recommendation of any investment strategy or product for a particular investor. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Talley Léger is an Investment Strategist for the Global Thought Leadership team. In this role, he is responsible for formulating and communicating macro and investment insights, with a focus on equities. Mr. Léger is involved with macro research, cross-market strategy, and equity strategy.

Mr. Léger joined Invesco when the firm combined with OppenheimerFunds in 2019. At OppenheimerFunds, he was an equity strategist. Prior to Oppenheimer Funds, he was the founder of Macro Vision Research and held strategist roles at Barclays Capital, ISI, Merrill Lynch, RBC Capital Markets, and Brown Brothers Harriman. Mr. Léger has been in the industry since 2001.

He is the co-author of the revised second edition of the book, From Bear to Bull with ETFs. Mr. Léger has been a guest columnist for The Big Picture and for “Data Watch” on Bloomberg Brief, as well as a contributing author on Seeking Alpha (seekingalpha.com). He has been quoted in The Associated Press, Barron’s, Bloomberg, Business Week, Dow Jones Newswires, The Financial Times, MarketWatch, Morningstar magazine, The New York Times, and The Wall Street Journal. Mr. Léger has appeared on Bloomberg TV, Canada’s BNN Bloomberg, CNBC, Reuters TV, The Street, and Yahoo! Finance, and has spoken on Bloomberg Radio.

Mr. Léger earned an MS degree in financial economics and a Bachelor of Music from Boston University. He is a member of the Global Interdependence Center (GIC) and holds the Series 7 registration.

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