The S&P 500, which represents about 80% of the U.S. equity market and is tracked by the C Fund, briefly reached new highs last week before correcting sharply downward on Friday.
For the past couple months since October, during this strong leg of the bull market, we’ve had sustained market volatility near record lows along with strong momentum. Stocks have marched upward in a gradual, orderly line, with no big up or down days.
However, looking at the long-term chart, the S&P 500 reached technical “overbought” levels according to basic technical momentum indicators such as the relative strength index (RSI) and moving average convergence divergence (MACD).
I indicated points of interest on this chart below with purple arrows and circles. At the top you can see the RSI, on the bottom you can see MACD, and in the middle you can see the S&P 500 price level itself:
When markets go up sharply for a sustained amount of time, they eventually “exhaust” the buyers, meaning that everyone who is buying is already doing so, and there aren’t enough remaining market participants to convert into fresh buyers.
The full year 2017 was the lowest-volatility year on record, and it culminated in a small melt-up top in January 2018 followed by an extremely sharp 10% downward correction when it unraveled. Investors had started betting heavily on “low volatility” strategies with leverage, meaning they were specifically making bets that volatility would remain low, so when even a small amount of volatility re-appeared in the market, many ill-planned strategies fell apart, and the market let off a lot of that pent-up pressure.
Here in January 2020, market conditions are not quite as overbought as they were in January 2018, but they are more overbought than any other recent period.
The Wuhan Coronavirus Outbreak
Over the past week, news about a significant coronavirus outbreak, emanating from the city of Wuhan in China, began making front page international headlines. It is being compared to the SARS outbreak of 2003.
In mid-January, headlines suggested that the virus was being contained. By Friday January 24th, however, five confirmed cases had been reported in the US including in Seattle and Chicago, as well as in Thailand, Japan, Australia, and other regions. News out of China became more dire over the weekend, with well over two thousand confirmed cases, triple the amount from days prior – with some modeling indicating a geometric increase going forward.
China responded by quarantining the whole city of Wuhan, which has a population roughly equivalent to New York City, and is linked by high speed rail to other major cities throughout China. Since then, China has quarantined a number of other cities as well, putting the total number of quarantined people at over 50 million by some estimates, comparable to the population of Spain.
Because the virus has a long period of dormancy before showing symptoms, we won’t find out for weeks to what extent this virus has actually spread.
Major virus outbreaks tend to negatively impact markets for a number of weeks, but rarely have sustained effects. This virus may negatively impact China’s GDP, which then could ripple to the various economies that it is strongly tied to, including Europe, the United States, Australia, and multiple Asian countries.
The tail risk is that it could end up being worse than other outbreaks in recent history. China has a lot more development since the SARS outbreak from 17 years ago, including high speed rail connections and exponentially more international travel. It’s obviously too soon to say how significant this outbreak could be for international markets but in the short term it has turned sharply down.
In the meantime, an overbought market is ripe for potential correction, and is why diversification is so important. When volatility is low and equity valuations are high, it only takes a small disruption to trigger a selling event.
Having exposure to all of the TSP funds can spread out your risks to reduce your impact from any one area.
An IRA or other account can be used to hold additional asset classes that are not available in the TSP for further diversification. It’s also critical to build a strong personal financial situation outside of your portfolios, including paying down debt and building an emergency fund for life’s various surprises.