The Bottoming Process—A Step-by-Step Guide - Wells Fargo Investment Institute

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The Bottoming Process—A Step-by-Step Guide

Wells Fargo Investment Institute - March 30, 2020

by Sameer Samana, CFA, Senior Global Market Strategist 

Key takeaways

  • After an almost 35% decline, the S&P 500 Index of large-cap U.S. equities staged a sharp recovery last week of close to 20%.
  • Given the quick gains, investors may now be wondering if the worst is behind us, and whether it is time to rush back into equity markets.

What it may mean for investors

  • We believe, and history concurs, that markets need time to fully recover after such a significant drawdown.
  • We believe investors would be well-advised to maintain recommended equity allocations within portfolios, rather than leaning too heavily into stocks.

Given the recent drawdown and rebound in equity markets, we thought it would be helpful to remind investors about the historical framework we use when assessing whether markets have bottomed, from a technical analysis standpoint. In essence, we view the bottoming process and its gyrations as falling into one of three phases: the Breakdown, the Consolidation, and the Bullish Breakout.

Below, we take a look at some of the tendencies each of these phases displays, based on price action during previous periods of turbulence. 

Phase 1: The Breakdown

Markets in uptrends tend to look at new developments, especially negative ones, through a glass-half-full lens and are initially quick to dismiss those developments as insignificant, with the most recent example being the first signs of coronavirus (COVID-19) cropping up in China. Over time, the damaging impacts of the new development continue to nag at market participants and lead to negative surprises on the economic and fundamental data fronts, making it harder and harder to ignore them. Eventually, there is an acceptance that the investing environment has changed, and investors must mark down their outlooks and reposition by selling risk assets, such as equities.

Unfortunately, when the trend changes from higher to lower, the herd must reposition portfolios simultaneously, and that can lead to bouts of illiquidity, which in turn can lead markets to overshoot their fair value. Defining characteristics of this phase tend to be spikes in volatility, oversold markets, and washed-out market internals (for example, very few stocks at 52-week highs or deteriorating cumulative advance-decline lines). It is worth noting that the Breakdown Phase tends to be the shortest of the three phases in the bottoming process. Based on what we see in Chart 1, which overlays the trajectory of the current S&P 500 Index price (orange line) against the bear market of 2008-2009 (purple line), we believe that we are currently in the latter stages of Phase 1 or at the very beginning of Phase 2. 

Chart 1. Bottoming of equity market is a process, not a price

Chart 1. Bottoming of equity market is a process, not a price

Sources: Bloomberg and Wells Fargo Investment Institute, as of March 24, 2020. The S&P 500 Index is a market-capitalization-weighted index considered representative of the U.S. stock market. For illustrative purposes only. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Guidance – For investors who went into the market breakdown with portfolios that were in line with recommended allocations, the decline in asset values has led to underweights in risk assets. We believe this presents an opportunity to rebalance to those allocations by selectively purchasing high-quality stocks with good growth prospects that could assume market leadership coming out of the downturn. Currently, we favor the U.S. Large Cap and U.S. Mid Cap asset classes, and the Information Technology, Communication Services, Consumer Discretionary, and Financials sectors.

Phase 2: The Consolidation

Once the selling exhausts itself, markets historically have tended to jump sharply off the lows and retrace a good chunk of the price decline. Unfortunately for investors’ frayed nerves, this is the very beginning of the Consolidation Phase, which is often the longest of the three phases in the bottoming process. After the initial retracement is over, and investors realize that a V-shaped bottom is highly unlikely and that they are going to be living in the new regime for the foreseeable future, markets often retest the previous lows. During this retest, markets also can reach new lows from time to time. Once a well-defined trading range has been established, markets wait as long as needed for the underlying issue to resolve itself and for the economic impact to become clearer. These are signposts that Phase 2 is underway. 

Guidance – For investors, the Consolidation Phase historically has presented the biggest test of emotional fortitude and investment discipline. Sharp rallies can present a siren song of opportunity that will try to entice investors back to the lowest quality areas—with promises of quick gains—only to be dashed quickly by disappointments that lead us back to the lower end of the trading range. We believe investors would be wise to trim exposure to U.S. Small Caps, Emerging Market Equities, and Developed Market ex-U.S. Equities, as well as the Energy, Materials, and Industrials sectors on the bounces. Investors should focus new purchases in areas with better risk-reward outlooks, in our view, like the ones mentioned at the end of the Phase 1 section above—and even then, only on price weakness.

Phase 3: The Bullish Breakout

If much of Phase 2 is defined by a stalemate between bulls and bears, Phase 3 is kicked off by a breakout above the upper end of the trading range. This is an initial signal that the bulls may finally be regaining the upper hand.  By this point, the economic and earnings outlook should be coming more clearly into focus, and growth should be turning back toward the positive side. The real debate becomes what valuation multiple investors are willing to pay for those earnings. Any pullbacks in this phase have tended to be short and shallow, frustrating investors who may be looking for one more retest of the lows as a chance to buy equities.

Guidance – Investors may have to fight an initial bout of skepticism that markets really are back in an uptrend. They may be tempted to continue selling rallies in the hopes of being able to buy back at lower prices. We believe this is the time to continue maintaining allocations, while taking care not to lean out too far over their skis in equities.

Where are we currently?

  • We believe we are currently in the latter stages of Phase 1 (the Breakdown) or the very early stages of Phase 2 (the Consolidation).
  • We do not expect a V-shaped recovery, and we think the equity markets should face plenty of overhead resistance the higher they climb. 
  • We expect markets to eventually carve out a trading range until more progress is made on the containment and treatment of coronavirus and until investors can get a clearer view on the eventual impacts to the economy and corporate earnings.

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