foxex: Not Scared Enough

Chart Advisor | Focus on the Price

Monday, January 27, 2020

1. Investors sold but did not panic...yet

2. Stocks brace for seasonally weak conditions

3. Energy stocks catch an Asian contagion

Market Moves

Stocks fell dramatically at the open on news that the coronavirus originating from Wuhan, China has continued to spread rapidly and millions have been quarantined. If the news panicked investors over the weekend, it didn't seem to bother them much more during the regular session.

The S&P 500 (SPX), the Nasdaq 100 (NDX) and the Dow Jones Industrial Average (DJX) all closed more than 1.5 percent lower, a bigger move than typical in recent days. When investors get nervous about their positions, fund managers and professional investors seek to protect their portfolios by reducing risk. In addition to whatever else they might do they will also try to sell away more risky positions and hold on to those stocks they think will fall the least. That usually translates into selling small cap stocks under times of stress. However, investors are not responding that way this time.

The Russell 2000 small cap index (RUT) closed only one percent lower today and rebounded slightly better, compared to the large cap indexes, from its initial fall at the market open. This kind of market activity will often indicate that sellers are likely to quickly become buyers. If so, they may not stay that way for long.

Stocks Brace for Seasonally Weak Conditions

As stocks pull back a total of three percent from Friday's previous high-water mark, it's useful to consider an effect on the market that is easy to miss--that of tax-driven selling among investors. Accredited investors may have more exposure to tax incentives than others, but anyone who invests or trades using funds not included in a tax-advantaged retirement account will need to be aware that their gains can be taxed at two different rates in the U.S. depending on how long they hold on to the shares they bought.

Those who hold a position less than a year are subject to ordinary income tax rates, while those who hold shares longer than one year are subject to long-term capital gains tax rates. The latter are typically lower for investors in higher income brackets. What that means is that all things being equal, such investors would rather wait at least a year to sell any stock they bought.

So what happens when a considerable collection of investors purchase stocks on or near the same date? Is it possible that they could inadvertently sell some of their shares at the same time, thus creating a wave of selling throughout the markets? In fact there is some evidence for this. Over the past 26 years, any time the S&P 500 has climbed more than seven percent in a month, it has led to an average decline in prices roughly 56 weeks later.

The chart below shows the last three such periods (marked at the beginning of the green lines), and the more pronounced selling that occurs at the end of them (marked by red shaded and yellow shaded areas). The timing of this recent market shock may be unfortunate as the index are coming up on a time when investors may be more likely to sell shares than usual.

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Energy Stocks Catch an Asian Contagion

One sector that has been heavily hit by the coronavirus news is the energy sector. Anticipated drops in demand for travel and energy commodities have weighed on oil prices. That has pushed energy stocks unexpectedly lower. With less than a week to go before earnings, shares of Exxon Mobil (XOM) have dropped significantly below support, extending the weakness in demand for these shares at a critical time.

The Bottom Line

Stocks dropped big before the open, but didn't continue to fall further, suggesting that investors aren't as scared as they might be over the news about coronavirus outbreaks. However these conditions might escalate as some investors become more concerned about selling in the near future. Among those stocks most likely to be vulnerable are those that are already weak such as stocks in the energy sector.