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Market Insights: Equity performance following sharp drops in industry breadth

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Equity Performance Following Sharp Drops in Industry Breadth

The first ten days of February were certainly gut wrenching and, in some measures, a historic short-term correction. Specifically, we saw the CBOE Volatility Index post its biggest one day increase of all time (data going back to 1990) on February 5th with markets bottoming out four days later after a double bottom sequence washout. This extremely sharp and quick correction from January 26th to February 9th resulted in close to a 12% drop peak to trough for the S&P500 in just ten trading days, and almost exactly a 10% correction the S&P/TSX Composite (although our correction was a bit longer with the peak being January 4th).

We have reassured our clients that the positive fundamental thesis we have had been in place since the second quarter of 2016 remains intact. Our MAM Recession Risk™ Composite has not changed much over this recent period. With rising interest rates and inflation, we have seen a sentiment change resulting in a re-pricing of risk over the short-term. It is difficult say if the correction is over for sure, but based on our analysis we see the probability higher than not that we have put in the low on this correction. If that doesn't play out, we feel a worst case scenario is another retest of this low in the coming weeks with a possible break, but then ultimately moving meaningfully higher from there. From an intermediate and long-term perspective, we do not believe this to be the beginning of a bear market, and we continue to assess equity markets as being in the second leg of a secular bull market which likely has a fair way to run.
We have seen an immense amount of analysis (both negative and positive) over the last couple weeks, but we wanted to share two items that we think are interesting or important. We will share the first one this week, and the second next week. One characteristic of the recent correction was there wasn't anywhere to hide except for cash, as rising interest rates have taken their toll on parts of the fixed income markets as well. In looking at the S&P 500, we had an extreme change in industry Group breadth. The amount of Industry Groups that were trading above their 50-day moving averages was steadily in the 90% range for quite some time, but then quickly took a nose dive on this correction, bottoming out at just 4.2% (only retailers survived the rout).

                                              Source: Bespoke Investment Group,

We will highlight here that a severe drop in the percentage of industry groups trading above their 50-day moving average over such a short period of time is very rare. In fact, going back to 1990, an 80 percentage point drop over a two-week period has only occurred ten times including this time, and this is only the third occurrence since 2010. 

                                                Source: Bespoke Investment Group,

What is interesting about this washout is that, in the nine prior instances, the performance of the S&P 500 following such drops in industry group breadth has been very strong. Although average returns over the following month have been decent in the past (+3% and positive two thirds of the time), it is the periods over the following three, six and twelve month periods that have been most impressive. Over these periods, the average future performance of the S&P 500 has been 8.3%, 13.6% and 19.8% respectively, and these returns have been positive 100% of the time over three and six months and just one negative prior instance twelve months out. We like those odds, especially in context of a fundamentally positive backdrop of stronger economic and earnings growth.