Key takeaways

  • Markets suffered another bout of turbulence, but lower Treasury yields and less-crowded positioning should make this round less troublesome.
  • We think the bottoming process will take some time, as investors take their time in moving past the initial volatility and refocus on the fundamentals.

What it may mean for investors

  • We believe that investors should take advantage by maintaining full allocations to equities, especially as others are forced to sell.

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Markets suffered another bout of turbulence as investors remain wary about increases in interest rates and inflation. The announcement of new tariffs by the Trump administration on steel and aluminum imports was also unhelpful as it added a new worry for investors, namely the possibility of retaliatory measures and a trade war. While there may be a sense of déjà vu on the part of investors still smarting from the early February sell-off, we believe there are important differences in the current market environment that are worth noting.

First, the catalyst for the earlier sell-off was quickly-rising U.S. Treasury yields. During this sell-off, yields have actually fallen and now sit close to a one-month low. Second, the previous sell-off was exacerbated by investment strategies that made large bets on a continued drop in equity volatility, which then were forced to unwind those concentrated positions once volatility began to rise. 

The sharp rise in volatility, in turn, impacted the behavior of other investors, who use the volatility measures as a signal for how much exposure to have toward equities, thereby creating a negative feedback loop. Futures positioning data show that these strategies have already reversed course and now have a large bet on volatility rising, rather than falling, and volatility measures have subsequently returned to more typical levels.

We have said since the early February lows that there had been a regime shift in markets, and that the high-return/low-volatility days were in the rearview mirror. We also expected some type of retest and consolidation, and the recent action was very much in line with those expectations. There is strong psychological support for markets at the 50% and 61.8% retracements of the initial rally from the February lows (2661 and 2631 on the S&P 500 Index; see Chart 1), and again at the 200-day moving average (2560). From the current price, these levels suggest potential additional downside of 1-4% for the S&P 500 Index.

Chart 1. S&P 500 Index with key technical levels

Chart 1. S&P 500 Index with key technical levels

Source: Wells Fargo Investment Institute, Bloomberg; March 1, 2018.

In addition, we expect that investors will find equities fundamentally attractive at these support levels, especially as volatility subsides, and the focus on fundamentals returns to the markets. Any further fall in Treasury yields should only serve to help by reducing the anxiety around rising interest rates and reduce the competitiveness versus equities. We believe that investors should remain disciplined and take advantage of others’ forced selling as an opportunity to maintain full allocations to equities—especially as our year-end targets for domestic equities continue to suggest a healthy year of equity returns from current levels.

While the probability remains low, we cannot completely rule out a repeat of early February, as there is the possibility that additional investors, beyond just the strategies mentioned above, sour on stocks. If that type of dislocation were to take place, where we fall below the levels laid out above, especially amidst a strong fundamental and economic backdrop, we would consider a more tactically positive stance on equities to show our conviction that the positive market cycle for equities is not yet over.