Global markets were conspicuously riled by reports of the new coronavirus outbreak in China. Yet many investors wondered why the selling pressure in the U.S. and overseas financial markets lasted for as long as it did, especially given the limited number of virus cases outside of China. The reason for the prolonged selling pressure was because China’s equity market was closed in observance of a major holiday. In this report, I’ll make the case that now that China’s equity market has re-opened for business, the process of discounting the damage will be quick, and we’ll soon see confirmed market lows for stocks, commodities, and U.S. Treasury yields.
After being closed for more than a week due to an extended Lunar New Year holiday, China’s stock market re-opened on Feb. 3, collapsing 8% and posting one of its worst losses in years. The negative reaction to the coronavirus after several days of pent-up selling pressure was widely expected, and once Chinese traders finally got their chance to sell, the outcome was inevitable. According to CNN, Monday’s decline erased a total market value in China of $445 billion. The damage inflicted by the panic-related selling can be seen in the following graph, which features the Shanghai Composite Index.
In response to the enormous selling threat, China’s People’s Bank said it would purchase 1.2 trillion yuan (or US$174 billion) of short-term bonds for the purpose of maintaining liquidity. China’s monetary authorities are doing aggressive battle to prevent a financial panic from spreading, and these efforts are likely to be ultimately successful.
Indeed, a major reason why the U.S. stock market remained under selling pressure last week – despite the fact that the coronavirus is fairly limited in scope and has done far less damage than the current U.S. flu season – was precisely because China’s stock market was closed. U.S. and other international markets were clearly waiting for Chinese markets to price in the virus’s impact before moving in to buy the latest dip. Now that the anticipated collapse in China’s market has happened, investors will begin the process of sifting through the proverbial rubble and finding bargains over the next several days.
The anticipated bargain hunting will obviously include beaten down stocks in the beleaguered energy sector. As previously observed, the most extreme weakness in the U.S. equity market has been concentrated in the oil and gas stocks which stood to lose the most from the health-related news headlines. Oil prices collapsed after the new coronavirus outbreak was first reported, which was obviously a reaction of investors’ fears of a worst-case scenario for China’s manufacturing outlook in the virus’s wake. The depth of the oil price collapse can be seen in the following graph of the WTI crude oil price.
As a result of the collapsing oil price, oil and gas-related equities began showing up in increasing numbers on the major U.S. exchanges. Now that China’s stock market has re-opened, and the virus’s damage on Chinese equities has been quickly assessed, I expect that we’ll see a bottoming out process taking place in the U.S. equity market.
While the new 52-week lows on both the NYSE and the Nasdaq numbered well into the 80s at the start of the latest week, there was some improvement from last week’s triple-digit readings. New lows remain above the historical norm, however, which tells us that there’s still some residual selling pressure in the broad market relating to China’s scare. On both the Nasdaq and the Big Board, the stocks making new lows are still mainly relegated to the energy sector along with several China ADRs. This in itself is a good sign for the U.S. broad market outlook since it suggests that the recent selling pressure is narrowly focused to just a couple of major segments.
While the reason behind the recent selling pressure in the energy sector is easy to discern, we should start to see a bottoming out process in the energy sector in the coming weeks. My best guess is that we’ll first see the U.S. major indices confirm lows within the next few days, followed closely by U.S. Treasury yields. Then, the leading commodities, including copper and oil, will bottom out and start to recover. Finally, China’s stock market should respond by moving higher as well.
Below is a graph of the continuous futures copper price. It’s quickly apparent here that copper’s collapse was overdone during the initial panic relating to the coronavirus outbreak. Copper is quite sensitive to perceived changes in China’s manufacturing outlook, so we should also see a sharp rebound in copper at some point in the coming weeks. An extended copper price rally would be most welcome, for it would tell us that investors have fully discounted the potential global economic damage relating to the virus.
As for the U.S. equity market, we’ll know that it has completely discounted the widespread coronavirus fears when we see the number of new 52-week lows on the NYSE and Nasdaq shrink below 40 for several days. Whenever the new lows are below 40, it indicates a normal, healthy market that isn’t plagued with any internal selling pressure. A 2-day higher close above the 15-day moving average in the benchmark S&P 500 Index (SPX) would also tell us that buyers have regained control of the immediate-term (1-4 week) trend, based on the rules of my trading discipline.
In conclusion, the U.S. financial market should be able to quickly discount the worst-case-scenario involving new strain of coronavirus now that China’s stock market is open for business after a lengthy holiday-related closure. As I’ve previously stated, the fact that the recent selling in global stock and commodity markets had a clearly identifiable news-related catalyst (namely the virus), and this will make it easy for investors to evaluate and fully price in the potential impact of the virus on markets. Consequently, a bottom should soon be confirmed for stocks, commodities, and U.S. Treasury yields.
On a strategic note, until the new 52-week lows on the NYSE diminish, participants should remain short-term cautious but look for buying opportunities among beaten-down stocks in fundamentally sound industries. Investors can also maintain a bullish intermediate-term (3-6 month) bias based on the prevalence of liquidity and the continued growth of forward earnings and revenue expectations for U.S. corporations.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.