Occasionally, markets get into a state of fear or euphoria that causes the future to be discounted to an extent that stretches the links between asset classes. When markets are in such an irrational state, it is difficult to anticipate a logical support or resistance area using technical analysis. That is just one of the reasons why Flexible Plan Investments does not make investment decisions based on forecasts or predictions. We use real data and rules that are tested over time and in different market and economic environments. The benefits of our approach can be seen in the performance of our strategies and portfolios in recent weeks.
Let’s look at the link between stocks and government bonds. Historically, when investors get fearful and sell stocks, much of the capital that flows from stocks often flows into the safe haven of government bonds. We have seen this lately.
Looking at the three-month return on stocks minus the three-month return on government bonds, we see that this relationship was in the 98th and 99th percentile over the past several days. This does not mean it cannot go further. It simply puts in perspective how stretched this difference in performance has been. We have seen similar readings over the past 35 years, notably in late 1987, the third quarter of 2002, late 2008, early 2009, and August 2011. All of these occurrences were near the end (not necessarily at the end) of significant stock market declines.
The graph below illustrates this relationship. It shows that when stocks get way ahead of bonds, as they did in September 2018, the gap between government bonds and stocks tends to close before we see higher prices in stocks. The converse is happening now. This condition suggests that investors have stretched the sale of stocks and the purchase of bonds to historically significant extremes. The causes of these types of extremes in the market may be different, but, quantitatively, they all look and feel similar to investors. The story of the coronavirus and its impact on world markets and economies has yet to play out, but we will continue to follow the data and our rules.
From a technical perspective, the S&P 500 is in a broad support zone that may provide some respite to the selling. The lower bound of that zone is level B in the following graph, which is at about 2,600 on the S&P 500. You may notice a similar pattern in this decline to that of late 2018. In 2018, the S&P declined from the September high to the level B support line, consolidated briefly, and then spiked down to the low at C. From the February 2020 high at D, the S&P 500 declined to just under what was then support at level A. It then bounced up sharply for a week and then began its spike down and is likely to test level B this week.
In the meantime, Flexible Plan will continue to do more of what is working now and has worked in the past, which is to stick to our objective, rules-based approach. It is what we know we can rely on in an emotional and fearful environment in which investors often make mistakes.