A Recession Doesn’t Mean Doom for the Market

A Recession Doesn't Mean Doom for the Market

Tips for Financial Advisors from Nasdaq Dorsey Wright

The economic fallout from the COVID-19 virus continues to grow and in the midst of such widespread consequences, many analysts and pundits have begun to talk about the big R – recession – a word that strikes fear in hearts of Main Street and Wall Street alike. This is especially true because the Great Recession was followed directly by the recently-deceased bull market and therefore still looms large in the minds of many.

The possibility of a recession is certainly cause for concern. Recessions are often accompanied by a host of adverse conditions like increased levels of unemployment and homelessness. In addition to the negative societal impacts, many investors also fear a recession because they associate recessions with steep drawdowns in equity markets. This association is not wrong per se – we do often see steep drawdowns in the equity market around the same time periods of economic recession.

Where many investors go astray is that they believe recession is an indicator that the market will decline. Therefore when talk of a recession begins to surface, often their first instinct is to dump their equity exposure. What they need to realize, however, is that the equity market is a leading economic indicator as opposed to a trailing economic indicator.

In fact, the S&P 500 is included as part of the Conference Board’s Leading Economic Index for the U.S. And if we look back, some of the best buying opportunities have come when the economy was in a recession.

Let’s take a look at our current situation. One common definition of a recession is two consecutive quarters of negative GDP growth. Real GDP growth for 4Q 2019 came in at an annual rate of 2.1%, according to the U.S. Bureau of Economic Analysis. So, by the two-quarter definition, we would need to see negative GDP growth in Q1 and Q2 2020 to officially have a recession.

Even if it were somehow announced tomorrow that we’re in a recession, how helpful would that be? Would it help you avoid the approximately 30% decline the S&P 500 has experienced in the last four weeks? The equity markets have already reacted strongly to a potential economic downturn brought on by COVID-19 and the Nasdaq Dorsey Wright Dynamic Asset Level Investing (DALI) asset class rankings have already shifted to favor exposure to fixed income and cash over equities. And if we judge by large sell-offs in the past, we’re probably closer to the bottom than we are to the top. 

In hindsight, it often seems obvious that the market was irrationally oversold and recovery was imminent. However, things can seem very different at the time. Coming out of the Global Financial Crisis (GFC), the market hit its lowest close on March 9, 2009. But, at that time, the US economy was still officially in the midst of a recession and the unemployment rate was still growing.

On April 3, 2009, the New York Times ran an article with the headline “663,000 Jobs Lost in March; Total Tops 5 Million.” In the US, the recession was not officially over until June 2009 and it wasn’t until months later (when economic data for the subsequent quarter showed positive growth) that the end of the recession was announced.

The point being that, while the market had already reached its bottom, there was still plenty of economic news to be pessimistic about. As we said, however, the market is a leading indicator of the economy, meaning that the market probably has more to tell us about the direction of the economy than vice versa.

While we may not be able to rely on economic indicators as they tend to lag the market, and we may not want to rely on our judgment in a period when we’re likely to be seeing negative headlines on a daily basis, one thing we can do is look to market-based indicators to give us the lay of the land. One of the main indicators we look at to determine when the equity market has become washed out is the NYSE High Low Index NYSEHILO. NYSEHILO counts the number of stocks on the New York Stock Exchange (NYSE) hitting new 52-week highs and divides that number by the number of stocks hitting new 52-week highs and new 52-week lows and we then take the 10-day moving average of that number and plot it on a Point & Figure chart.

Trips below the 10% level are rare and tend to indicate a market that has become washed out and reversals up into Xs from these low levels indicate that demand is coming back into the market and have historically provided good buying opportunities. With Wednesday’s trading, the NYSEHILO reached 2%, a historically low level which it has reached on only four occasions in the past 30 years.

The last time we reached this level was in the midst of the sell-off in Q4 2018. The HILO reversed up into Xs on January 2, 2019, just a few days after the market bottomed. From there, the HILO went “coast-to-coast,” making it all the way to the 92% level in a single column of Xs. The S&P 500, of course, notched a price return of almost 30% for the calendar year.

NYSE High-Low Index

Prior to 2018, the last time we saw the HILO fall all the way to 2% was in 2009. The indicator reversed up on 3/18/09, nine days after the market had bottomed. Of course, like any other indicator, the NYSEHILO is not perfect. As the chart shows, prior to its reversal up in March ’09, the HILO reversed up from 2% on 11/5/2008 and between that reversal and the subsequent reversal up on 3/18, SPX declined an additional 17%. Which is a valuable reminder not to think of any single indicator as a “magic bullet” or to look at it in a vacuum.

We would do well to treat these signals as we might treat the “all clear” signal from a lifeguard at the beach after a shark sighting. Just as we would re-enter the water cautiously, not bounding headlong into the surf with boogie-board-toting children in tow, we should re-enter the market cautiously, with a plan carefully mapped out, and with an eye to the horizon in case trouble returns.

NYSE High-Low Index

Just as they have following every major drawdown, at some point, probably in the not too distant future, the HILO and our other indicators will give us the all-clear signal once again. When that happens it is quite possible that we still are feeling the negative economic effects of this epidemic; it is possible the economy could even be in a recession. But, as we’ve seen, the market recovery is likely to lead the economic recovery and we must be prepared to re-enter the water cautiously even if things still seem a bit shaky on the surface.

Nasdaq Dorsey Wright offers investors a free trial of the NDW Research Platform, which provides turnkey research and analysis for securities selection, portfolio management and asset allocation. Click here for more information. For questions about the NDW strategies, contact us here.

Dorsey, Wright & Associates, LLC, a Nasdaq Company, is a registered investment advisory firm. Registration does not imply any level of skill or training.

Unless otherwise stated, the performance information included in this article does not include dividends or all potential transaction costs. Investors cannot invest directly in an index. Indexes have no fees. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss. 

Nothing contained within the article should be construed as an offer to sell or the solicitation of an offer to buy any security. This article does not attempt to examine all the facts and circumstances which may be relevant to any company, industry or security mentioned herein. We are not soliciting any action based on this article. It is for the general information of and does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Before acting on any analysis, advice or recommendation (express or implied), investors should consider whether the security or strategy in question is suitable for their particular circumstances and, if necessary, seek professional advice. 

Dorsey Wright’s relative strength strategy is not a guarantee. There may be times when all assets are unfavorable and depreciate in value. Relative Strength is a measure of price momentum based on historical price activity. Relative Strength is not predictive and there is no assurance that forecasts based on relative strength can be relied upon to be successful or outperform any index, asset, or strategy. 

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