The outlook on the COVID-19 pandemic continues to trigger swings in financial markets. Here we present our framework to analyze whether or not markets could retest lows. To get a clearer picture we ask questions to find corroborating evidence from related markets.
This too shall pass. Health authorities tell us that the spread of the COVID-19 virus could take another harsh turn if businesses reopen too soon or if a second wave develops during the autumn influenza season. The capricious nature of the virus spells ongoing uncertainty for workers and investors. Yet, the outbreak will ultimately pass, either through tireless treatment and containment practices, the so-called herd immunity, or a vaccine.
In turn, financial markets, being forward looking, will eventually begin to focus on 2021 and beyond. However, the market’s path is not going to be smooth and we expect false starts, surprises and economic potholes ahead. But waiting on the sidelines incurs a clear opportunity cost to investors who are underweight risk assets. What could distinguish a reasonable buying opportunity from a relief rally or even a dead-cat bounce? Several signals can help us assess the nature of an equity rally and whether to buy or to wait.
Has Short Interest Declined?
Overall, a decrease in short interest signals that bearish sentiment is declining. Short interest is the pessimists’ view on market direction and a reduction in short interest shows that the pessimists no longer like their odds.
We use proprietary indicators to measure short interest (since, as an over-the-counter market, short interest is not readily observable). This gives us visibility into whether global short interest is materially rising or falling; if short sellers were not covering positions in any material fashion, and therefore they were not the driver of the increase in equity prices, then the rally could be buyable.
How are Long-Only Investors Behaving?
The behavior of long-only funds gives further clues to understand market sentiment. The timing, pace and particulars of rebalancing activity also convey information, particularly when placed in the context of prior market crises.
Again, our proprietary datasets are exceptionally valuable since these cover a large portion of the world’s asset owners. We monitor the change in cash holdings from during the shock period to identify the trend itself and compare it to the period of the Lehman collapse. Further, we look at the aggregate split between risky and low-risk assets held, which we call the Behavioral Risk Scorecard, and compare trends to several periods of past market stress. Our extensive datasets provide unique insights into investor decisions during periods of high market volatility.
Does Futures and Options Positioning Align With the Underlying?
While technical analysis can sometimes yield insights, we believe new positioning in futures and options contains more information. The derivative markets provide a different lens on pricing behavior since retail investors hold little sway here. Moreover, derivatives tend to attract a different segment of institutional investors than the underlying securities. As a result, derivative markets provide unique evidence to either verify or contradict the behavior in the primary security markets. Each investor segment prices risk and reward, even though the two markets are obviously related.
The skills of fiduciaries and investment managers are being tested during the COVID-19 pandemic. Declines in market prices mean that many investors are below their target weight to risk assets. Yet, naïve rebalancing could expose investors to buying into short-term rallies only to be followed by further secular declines.
We leverage our proprietary databases to assess signals from related markets to evaluate conditions. We welcome opportunities to discuss prevailing market conditions with clients using the framework outlined here.
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