When markets drop, I always get calls from advisors and the media asking what the heck is going on. Volatility (at least when combined with a market decline) is often considered evidence that it’s time to worry—that something is broken. It makes sense; after all, if you’re losing money on your investments, something isn’t right. But, somehow, I don’t see the same reaction when there’s a market melt-up. No one called me yesterday to ask what was going on, anyway.
Maybe they should have. Both sharp drops and sharp increases are responses to the same problem: uncertainty. If we think of the stock market as a mechanism for matching investors with investments, then setting accurate valuations is critical. When values swing either way, it means that investors don’t really know how much opportunities are worth. And that’s a problem.
Uncertainty is now driving the market
Anyone who reads this blog knows that I am basically constructive on U.S. markets, though I did think we might see a much deeper pullback in the short term than we have seen. Yesterday’s rapid bounce back up does not really indicate that the volatility has ended, however. It’s just that—for that moment—investors decided that prices had been driven too low.
In other words, I have been worried about uncertainty, and the bounce back actually reinforces to me that uncertainty is now driving the market. What would it take to resolve the uncertainty? Barring convincing economic resolutions for the U.S. or China, which I don’t think we’re going to get in the foreseeable future, the answer will likely come from market evidence.
Resolving uncertainty: An analysis of S&P 500 support levels
Since the start of the year, the S&P 500 has bounced between roughly 2,000 and 2,100. In 2014, it ranged from 1,800 to just above 2,000. Over that two-year period, the 2,000 level marked first a ceiling and then a floor. There is, of course, no compelling theoretical reason why round numbers should have any special effect on the market, but the evidence shows they do.
One way for the market to show that uncertainty has been resolved, then, would be for the S&P 500 to break convincingly above 2,000. As of yesterday and even this morning, that looked very doable. (As I’m putting the finishing touches on this post, markets are now in slightly negative territory. Did I mention uncertainty?)
Even better, of course, would be for the market to move to new highs (i.e., 2,135 for the S&P 500), but a sustained break above 2,000 would be a necessary and important first step. Watch the market over the next couple of weeks to see if it can make that leap.
Beyond the simple 2,000 level, another way to look at resolving uncertainty is for the market to move back above long-term trend levels. Here the news is more discouraging, as all longer-term moving averages are well above 2,000, so there are no real intermediate steps before we get there.
The same, unfortunately, applies to valuations. My valuation analysis from the other day still holds. And, again, we find that there are no real support levels from a valuation perspective that could provide more certainty before we get back to the 2,000 level.
So far, my analysis deals with a potential return to growth. What about continued decline? The analysis is pretty much the same, but in reverse. From a market level perspective, 1,900 on the S&P 500 appears to be the next support level down, as we saw last month and also in October of last year, when markets briefly dropped below that level before bouncing back. A sustained break below 1,900 would be evidence of a potentially renewed downward trend.
The bottom line
As encouraging as yesterday’s surge was, we remain in a very uncertain market environment. I think we can expect to see market levels oscillate between 1,900 and 2,000, until investors, as a group, decide whether they are confident—or not. Large one-day moves in either direction do not, unfortunately, indicate a problem solved.