In comparison to its record performance in April, the stock market has been much more mixed in May. Financial markets have seen significant ups and downs through the first half of the month as optimism and concern trade mindshare amongst investors. As a result, the stock market has been unable to commit to a direction and traded largely within a defined range. The uncertainty has also resulted in large divergences between different sectors as investors weigh which parts of the economy will be better able to recover and which will take longer. At mid month, stock indices were mostly down; however, the technology heavy Nasdaq index has managed to maintain a positive performance due to investor confidence in tech megacorporations.
The nearly straight line rally from the depths of the crash in late March through the end of April was fueled by a combination of a technical rebound from oversold conditions as well as investor optimism that the economy could bounce back both quickly and strongly. By May, the technical and psychological factors that have driven the rally have started to taper off. Investors have been weighing a variety of issues that could derail a strong economic recovery.
While these concerns have weighed heavily on markets as a whole, not all sectors have been equally affected. The technology sector and in particular the tech giants known as the FAANGM have had a much stronger stock market performance than the broader economy, significantly fueling the recent rally. In contrast, many stocks from harder hit sectors are doing poorly enough that they may face delisting from the S&P 500 index. This divergence is clearly illustrated when comparing the gains of the tech heavy Nasdaq index in May to the losses suffered by other indices. This divergence may signal a shift in the economy or could be a temporary imbalance that will correct, but for now is a strong indicator that things will not be getting back to normal for quite some time.
The thrust of recent news has been strong enough to firm investor belief that a strong recovery is possible; but there remains a high risk of setbacks to reopening and recovery plans which could slow or reverse the rally. Investors seem to have an expectation that development of a treatment or vaccine for COVID-19 will eventually succeed and will be looking for signs of progress on that front. The expectation that the Fed and Congress will step in with further action to support the economy as needed is also another factor that has kept investor confidence up. Overall, markets are likely to retain upward momentum, though they may find it difficult to make significant progress beyond important technical levels.
With most regions of the country now in the process or planning to reopen, one of the first hurdles to the economic recovery seems to be falling away. The status of the pandemic and whether it worsens during these reopenings will be a major factor in how the market behaves in the coming weeks and months. A resurgence in cases or other signals that the reopening process needs to be slowed or reversed will have a strong negative effect on the market.
One of the potential problems is that a full reopening is contingent on being able to control the disease, something that will be very difficult to do without a treatment or vaccine. The seeming success of antiviral drug remdesivir having some effectiveness as well as promising vaccine progress from Moderna in combating the disease has helped keep expectations up that effective treatment will eventually be developed so the economy can fully reopen. Moving ahead, this optimism will likely wane without further progress in developing a medical countermeasure against COVID-19.
Despite the obstacles the economy faces in its quest to recovery, investors have a powerful ally in the US government. The multi-trillion dollar programs enacted by the Federal Reserve and Congress indicated they were willing to spend whatever was needed to support the economy. With another stimulus bill being debated in Congress and Fed Chair Powell’s recent comments that further action will be needed, investor confidence in government intervention will support markets and help keep them from plunging to their March lows even if the economy takes another turn down.
Looking at the charts, the S&P 500 has carved out a range over the past month between 2800 and 2950, bouncing between these levels. There is some psychological headroom on the upside to reach 3000, and the optimistic tilt of the market currently suggests the index will reach for that level. The index could easily move higher than this, but will find it difficult to sustain further rallying and would likely be pulled back down below this level soon after.
On the downside, the index has seen recent support at 2800, but this level will likely be taken out in a downturn in sentiment. Further down, previous support exists at 2700, 2625 and 2600. This trio of support levels should be able to buffer the market from further movement down unless we get a significantly nasty surprise which could take the index down near its March lows, but it is relatively unlike we will see the index drop below 2300 where it only visited during the height of the crash.
The market changed gears significantly in May as it became bound in a trading range. The change in the character of the market introduced new challenges for our trading strategy as we adapted to the new market environment. This has led to a loss for the month so far due to some of our trades being ill matched to the changing market environment. With the market still as tumultuous as it is, missteps will be unavoidable for any trader, but our flexibility enables us to adapt and keep up with the market to deliver a strong performance in the long run.
Our trading activity in May has been a mix of short term directional trades while reintroducing our traditional strategy of selling option strangles now that the market has calmed from its March hysteria. In beginning to trade our main strategy again, we attempted to fit the risk parameters to the market environment. Unfortunately, the wide fluctuations of volatility through the first half of May made that challenging, and we suffered losses when the level of risk in our trades was ill-matched to the market’s movements. We also took some losses in our directional trades as technical indicators we used to model the market in previous months were less successful in April.
Overall, this is a temporary setback. As we familiarize ourselves with the characteristics of the post pandemic market, we will be able to establish appropriate risk thresholds to trade safely and consistently. The continuing economic uncertainty will continue to make the market environment very lively, and provide plenty of opportunities for our trading strategy to deliver a strong performance through the rest of the year.