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  1. Home
  2. / Investing
  3. / Stocks

Fears of Coronavirus Could Make Market Selloff a Self-Fulfilling Prophecy

All stocks related to global economic growth, especially China, will get hit as expected demand is perceived to be hit.
By MALEEHA BENGALI
Jan 21, 2020 | 06:46 AM EST

Over the past week, the market has been showing signs of fatigue as it begrudgingly climbed up on lighter and lighter volumes -- with no consistent theme in stocks and sectors, as such. Bond yields, after their ascent towards the end of last year on the potential reflation theme, have been stuck below the 1.90% ceiling for now. Gold had a sharp move higher towards $1565/tonne after the Iran debacle that caught most by surprise, as Gold was heading lower before that as risk on trades took precedence. The trade deal was signed last week as expected. All the good news from central bank liquidity support to an economic rebound have been priced into the market and investors across the board are all-in as the worries of repo and recession are in the rear-view mirror. What could go wrong?

In one word, complacency. Most stocks and charts appear to show parabolic hyper extension trends which from a pure chartist point of view, have been suggesting a retracement of some sort to allow the stocks to mean revert back to at least touching their nearest moving day averages before continuing to move higher. Institutional and asset managers, including retail, are all fully invested in this market as it broke out over the past month. Fundamentals aside, the very near-term technical indicators remain stretched, which argued for a tactical pullback, other than anything ominous.

Volatility ($VIX) which is one of the most important measures of market trends, has been shifting lower and stubbornly stuck to the 12 level. The VIX Daily Sentiment Index (DSI) printed +9% Bulls three more times this week, stretching it to 12 days less than 10%. Historically speaking, this is one of the longest streaks ever, where 6 out of 7 prior streaks saw the VIX shoot up towards 20 or higher, taking the S&P 500 lower by 3%-10% over the next few weeks. More importantly, as mentioned last week, the front month VIX options expired and there was a tendency to lean over the 12 level to contain any rallies, given the extreme short positioning -- suggesting that post expiration, VIX would be allowed to move more freely. Given the higher lows and highs, it looked precarious. The market just needed an excuse to move lower and VIX gives it that.

There is no doubt that the Fed backstopped the market in September last year when it provided a platform to inject as much capital as deemed necessary to keep the overnight rates suppressed and expand their balance sheet by buying Treasury bills. The market took the cue, and rightfully so, to chase risky asset prices higher -- as has been the theme for the past decade as central bank money finds its way back into the system.

Inflation is not yet a concern for them and rates would be on hold for much longer, even lowered if the situation arose. Their end January meeting will be of vital importance to see if their tact has changed in any way. Global economic growth has been showing signs of stabilization, if not an actual pick up. Needless to say, equities have more than priced in the actual recovery for now. The rest remains to be seen.

Over the weekend, there have been reports of a coronavirus breakout that infected a few individuals in China. Chinese officials have now confirmed it can be spread by human-to-human  contact and the deadly disease is spreading to other nations, with five cases found outside China. This is reminiscent of the SARS virus of 2003, which put a halt on global travel, demand and tourism -- hurting economic demand, especially in Asia. Any chance of a SARS 2.0 outbreak in Asia can spark similar fears -- overnight markets are weak and certain sectors hit quite hard.

It is hard to quantify the impact now, but traders react first and ask questions later when they have had time to assess the spread and potential impact. In a market that has been struggling with lack of conviction to move higher and some profit taking that has not come despite many predictions for it, this event could be the self-fulfilling prophecy to cause the much-needed profit taking.

All stocks related to global economic growth, especially China, will get hit as expected demand is perceived to be hit. Copper is one of those commodities, hence the name Dr. Copper, that will be hit first as it is a direct representation of Chinese GDP growth. Copper has had a nice rally from the lows seen in Q4 2019 and stocks have moved 15%-25% higher, and can see some profit taking. But make no mistake, Copper has one of the best fundamental demand-supply pictures out there. But things never move up in a straight line forever. Oil, too, will be hit -- but less so, as it is less sensitive in a shorter period of time given ongoing seasonal demand dynamics, winter heating demand etc.

The market needed an excuse to see some profit taking as the new year started. This outbreak
could very well be the catalyst to do so. Judging by various technical indicators and put-call ratios that have been overextended, implying complacency and positioning, this is entirely possible. Calling an outright recession is far from clear, but this pullback will give you excellent entry points in your favourite names. It is always prudent to take profits at the top, keep some powder dry, to take advantage of these exogenous shocks to play specific stock investment stories.

Bears will use this pullback to hail doom and gloom, but it is important to separate the wood from the chaff. As long as the central bank liquidity gravy train is in full swing and monetary accommodation across the board, the pullbacks won't last long. After all, a healthy rally needs to see some pullbacks to normalize its over-extended state before moving higher.

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TAGS: Commodities | Gold | Investing | Markets | Oil | Politics | Stocks | World | Asia | China | United States | U.S. Equity | Global Equity

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