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State of the Markets

Wells Fargo Investment Institute - April 6, 2020

Bears Come Back Out In Spring

by Darrell L. Cronk, President, Wells Fargo Investment Institute, Chief Investment Officer, Wealth and Investment Management

In nature, every spring bears come out of hibernation. This spring the capital market bear also reemerged from its 11-year slumber with sharp teeth and claws that are already leaving deep scars. As the coronavirus outbreak spreads across the globe, equity markets officially entered bear market territory on March 12. Economic indicators like global purchasing managers’ indices, U.S. jobless claims, and nonfarm payrolls leave little debate that the economy also entered its next recession, with early data confirming this one could be a greater economic shock than what the 2008-09 global financial crisis delivered. 

The second quarter is beginning with a fragile consolidation across most markets. April brings potential negative and positive catalysts. The negative catalysts  center on more steeply contracting economic data, double-digit unemployment, and a tough first-quarter earnings season. A positive catalyst for markets includes a potential late-April decline in the growth of COVID-19 infections, followed by possible announcements of reopening schedules for key segments of the economy. 

How should we think about a bear market? From a historical context, the 13 bear markets since 1929 have averaged 20 months in duration and a 38.9% peak-to-trough drawdown. A typical bear market sees three phases. The first is a waterfall move downward as the initial shock weighs heavy on markets. This waterfall decline of 34% peak to trough for the S&P 500 Index occurred in a lightning fast 23 days, the fastest decline of that magnitude on record. The second phase, which we believe we have now entered, is an extended sideways movement or drift, where markets often see new lows—beyond the initial waterfall lows—before they find a final bottom. The third phase is a sustained rebound as investors obtain greater visibility in the outlook and seek out mispriced assets.

It is important to understand that this bear market and recession are still only in their infancies and investors will need time to adequately gauge their depth. Even though the past two weeks have brought asset-price retracements in response to the unprecedented speed and breadth of policy aid across countries, sectors, and instruments, the majority of markets have reversed less than one-third of their first quarter declines. The most recovered markets tend to be those in which central banks now buy or will buy assets in a sizable way. The Federal Reserve’s commitment to unlimited U.S. Treasury purchases is the primary reason Treasury yields remain near all-time lows—even as Treasury issuance approaches all-time highs to fund more than $2 trillion in deficits this fiscal year and next.

So how do investors decide when to begin repositioning for an eventual recovery? We have noted throughout this crisis that there is never one convincing indicator that signals a turning point in markets—rather, we look for a confluence of indicators that requires a judgment call on when and how to re-enter cheap markets. For us, these include:

1. A discernable peak in the number of reported COVID-19 cases. This key indicator has not yet been achieved. A month is a long time with an epidemic, but good initial signs from the World Health Organization and U.S. public health officials show Italy’s epidemic curve could flatten by mid-April, followed by the rest of Europe and the U.S. by the end of April.

2. A reversal in investor positioning. This condition, a shift out of risk assets and a search for liquidity and perceived safe harbors, looks to have largely occurred. Substantial deleveraging has taken place, and key sentiment indicators like the American Association of Individual Investors (AAII) survey now register more bears than bulls.

3. Recession-like pricing across financial markets. We are getting closer on this indicator, but we’re not there yet, in our opinion. Projections tend to be too conservative in downturns and upturns, which is why they are often revised in the same direction for several consecutive months as turning points in the business cycle evolve. For example, first-quarter earnings season begins in earnest April 14, with consensus earnings expectations of -7% year over year for first quarter and -14% for second quarter. These look conservative to us, considering that we expect a drop in U.S. gross domestic product growth that is likely to exceed the financial crisis, when earnings dropped 40% year over year.

There absolutely will be great opportunities for investors as a result of this recession and bear market, in our opinion, but it is equally important for investors to exercise patience, judgment, and awareness of conditions to watch for durable recoveries. I am an optimist by nature, but vitally crucial in our business is a clear-eyed sense of realism. It is no secret that scars left by bears can and do take time to heal.

This virus is infectious, but so is our collective will to adapt and respond. Social distancing and containment actions; swiftly coordinated and unprecedented policy support; and the initial evidence of cases peaking in other countries are all encouraging signs of progress. We are not all just bystanders, however. We are in this fight together and those on the front lines, like our healthcare workers, are the true heroes. We owe them a great debt of gratitude for showing us what true courage, selflessness, and compassion are all about. April will undoubtedly be a tough month to withstand, but we will make it through this to the other side.

Stay safe, stay patient, and stay home for now.

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