Morning Comment: Liquidation Phases Sometimes Come in Waves

The news that ABT could be coming up with a coronavirus test that gets results in 5 minutes and that JNJ announced a lead vaccine candidate over-shadowed the rising numbers of Covid 19 cases and deaths from over the weekend…to help the stock market rally more than 3%. It also got help from the rebalancing that seems to be going on for those investors who need to keep their equity market weighting up at a specific level.

We would point out, however, that the internals in the market yesterday were not as strong as they were during last week’s strong mid-week rally. The volume was 22% below the March daily average…and breadth was quite disappointing for a day that took the three major averages higher by 3%. It was just 3.5 to 1 positive on the S&P 500 index…and just 1.5 to 1 positive on the NYSE Composite Index!!! The upvolume vs. down-volume was only slightly positive as well. Thererefore, the “internals” of the stock market yesterday were not anywhere near as impressive as they were during the three-day midweek rally last week.

That said, it’s not a big surprise that the internals were not all that good. Given that the uncertainties surrounding the coronavirus are still very large, it’s no surprise that investors are not piling into the market and buying stock hand over fist. Yes, the “internals” were quite good last week, but that came in the immediate after-math of the end of some massive “forced selling.” When the market becomes “washed-out” after “forced selling” ends, the internals are always going to be exceptional in that initial rally. So the fact that they’ve faded a bit this week is not a major problem…at least not yet.

On top of the news from ABT and JNJ, the stock market also (probably) got some help from the “rebalancing” that certain funds have to do to get in line with their “weighting mandates” between equities and bonds. With the big decline in the stock market, some (quite sizable) managers had become underweighted in equities in a meaningful way…and thus have had to add to their equity weightings before the end of the quarter. Some of that re-weighting had already been done by the end of last week. (It is our understanding that GS said over the weekend that about 40% of it had already been done.) Well, more of it looks to have been done yesterday…and we’re sure a lot of traders are looking for more of it today. Therefore, we could see some more artificial fuel on the buyside of the ledger in today’s trading.

However, we do need to point out that these funds are not like index funds…who are tied to a certain price on THE day that an index is re-weighted. Index funds ARE tied to those price/weightings. Many years ago, they tried to “game” the situation by reweighting their index fund a little early…basically front-running the rebalance. However, they got burned a few too many times…and they decided to go ahead and do most of their re-weighting on the close of the specific day involved. (This is why we get a HUGE explosion of volume whenever we have a “Russell-rebalance” day.)

The other funds that we’re talking about now (some pensions funds, etc)…who have a requirement in terms certain weightings within asset classes do not have the same kind of requirement that index funds have. They can re-weight their portfolio several days early with impunity. As long as they are sure that the weighting will end the quarter a lot differently than the previous quarter (which was obviously the case this time around), they can get the vast majority of their re-weighting done earlier than the last day of the month/quarter if they’d like to…..In other words, if GS is wrong…and a lot more of that re-weighting has already been done…we might not get the kind of rally today that some traders are looking for.

Either way, however, the stock market will see a pull-back soon. After a 17% rally in just one week (and +20% on an intraday basis), the odds are pretty high that the stock market will need to take a “breather” as some point in the near future. That doesn’t mean we’re about to see another deep pull-back, but we’re going to be watching the “quality” of the next pull-back very closely.

If the pull-back is a shallow one…and is followed by another strong rally…it’s obviously going to be quite positive. However, if it is a deeper one…and it comes on another pick-up in volume and with breadth that is quite negative…it’s going to raise another warning flag on the stock market. In other words, if the “next pull-back” is met with a “buy on weakness” approach by investors, it’s going to be bullish. If, however, the “next pull-back” scares investors…and leads them to raise cash once again by selling, it will be bearish.

One of the things we believe is important is to understand right now is that “liquidation phases” do not always signal the end of a serious decline in the stock market. Yes, sometimes we only get one period of “forced selling”…and the stock market bounces back directly from the initial low. This is what took place in late 2018. However, sometimes there are several bouts of “forced selling” (several “liquidation phases”). We certainly saw this during the financial crisis. There were several bouts of “forced selling” before the Lehman collapse…one when Lehman actually did collapse…and another one several months later. We’d also note that there were several bouts of “forced selling” during the bear market after the tech bubble burst 20 years ago. What we’re saying is that when we go through a “de-leveraging process,” there are frequently SEVERAL episodes where “liquidation phases” take the market lower in a meaningful way.

We’d also note that you don’t even have to have more than one “liquidation” phases to create a retest of a low…or even an undercutting of an important low…before the ultimate bottom is made. This tends to happen more often in bear markets than in corrections, but sometimes investors just realize that the economy is not going to snap-back quickly. When that happens, investors “decide” to pare-back their holdings after the market has already declined in a material way…even though they are not “forced” to do so. In other words, when a deep decline is not followed by a recession, the market does not always see a retest or an undercut. (Think 2018.) However, if it IS followed by a recession, a retest and/or an undercut becomes much more likely.

In today’s situation, it is very difficult to know how long the coronavirus will keep the economy shut-down…and it’s very hard to figure out how much of a lasting impact this healthcare crisis will have on the economy. Therefore, we believe that a retest and/or an undercut of the March lows is likely….and we’ll be watching the quality of “the next decline” to see if that retest/undercut will come sooner rather than later. It’s also a key reason why we believe that a strategy that involves buying the stocks of high quality companies…on a very gradual “scale-down” basis…is the best strategy to follow right now.

Matthew J. Maley

Managing Director

Chief Market Strategist

Miller Tabak + Co., LLC

Founder, The Maley Report

275 Grove St. Suite 2-400

Newton, MA 02466


Although the information contained in this report (not including disclosures contained herein) has been obtained from sources we believe to be reliable, the accuracy and completeness of such information and the opinions expressed herein cannot be guaranteed. This report is for informational purposes only and under no circumstances is it to be construed as an offer to sell, or a solicitation to buy, any security. Any recommendation contained in this report may not be appropriate for all investors. Trading options is not suitable for all investors and may involve risk of loss. Additional information is available upon request or by contacting us at Miller Tabak + Co., LLC, 200 Park Ave. Suite 1700, New York, NY 10166.

Posted to The Maley Report on Mar 31, 2020 — 8:03 AM
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