The bond market thinks the Dow Jones is headed for another downturn. And the coronavirus outbreak may prove bond investors right.
The Dow Jones has been on a very volatile run over the last few days. The index has moved by over 3% in the last eight out of ten trading days. With the CBOE VIX Volatility Index still above 60, you can expect the fireworks to continue.
The Dow witnessed three rapid 4% or more rallies in the last few days. But it has failed to provide a follow-up move and has instead continued moving lower. There are three reasons why this trend is set to continue.
Bulls were taking a victory lap when the Dow Jones jumped 5% Mar. 2. I opined that the violent jump was indicative of a bear market rally. And the markets have tanked over 10% since then.
Tuesday’s rally—which was driven by President Trump’s stimulus plans—suffered a similar fate.
Based on historical data, a strong rally immediately succeeding a brutal collapse has been symptomatic of a bear market. Six out of the last seven times this has occurred in a bear market.
The same trend can be observed for the S&P 500:
According to an old Wall Street adage, the bond market is smarter than the stock market. Since bond investors are more risk-averse, the price action of bonds can often predict a subsequent move in the stock market.
A significant increase in credit spreads accompanied Tuesday’s Dow Jones rally. This isn’t a sign of a healthy market.
Widening credit spreads suggest that the creditworthiness of corporate and private borrowers is declining. Creditors are concerned about debtors’ ability to service the debt. So, if the bond market is smarter than the stock market, the Dow Jones is headed for another crash.
The coronavirus outbreak is exploding around the globe. The pandemic has forced countries like Italy and China to shut down their economies completely.
Coronavirus is likely the primary cause behind the widening credit spreads. When economies are shut down and people stop producing, companies don’t make money. And when they don’t make money, they can’t service their debt.
So, widening credit spreads aren’t unexpected. But the situation will likely get worse when the coronavirus brings the U.S. economy to a halt.
Italy’s government didn’t take the necessary measures to contain coronavirus when it first started spreading in the region. Human beings don’t have an innate understanding of exponential functions. When the number of coronavirus cases in Italy was in the double-digits, people were still comparing it to the flu. But since the disease is spreading exponentially, things quickly spiraled out of control.
The U.S. government’s approach to containing the spread has been even worse. Not only has President Trump himself downplayed the threat, but the U.S. is not yet testing enough people.
Worse, data suggest the U.S. is lagging Italy by just 11.5 days. Given the U.S. government’s lackadaisical approach, the outbreak in the country could get much uglier than in Italy.
What’s more, President Trump didn’t do a great job when he addressed the nation on coronavirus Wednesday:
The markets were expecting Trump to announce preemptive containment measures. Instead, he blamed European nations for exporting coronavirus to the U.S. Unsurprisingly, Dow futures crashed over 5% after the speech.
The U.S. government will soon be forced to replicate Italy. The Dow Jones is down considerably over the last two weeks. But a complete lockdown in the U.S. is not priced in, setting up the market for another brutal crash.
Disclaimer: This article represents the author’s opinion and should not be considered investment or trading advice from CCN.com.
This article was edited by Sam Bourgi.
Last modified: March 12, 2020 1:25 PM UTC