Why 'exhausted' market is poised to take a breather

Chief investment strategist compares crash and rally to three phases of human's response to stress

Why 'exhausted' market is poised to take a breather

Markets will need to take a breath and reassess after the tumult of the past six months.

That’s the view of Philip Petursson, chief investment strategist and head of capital markets research at Manulife Investment Management, who has compared the recent investment period to how people respond to stress, which is often referred to medically as general adaptation syndrome (GAS).

The theory, created by Dr. Hans Selye, typically follows a three-stage process that describes the physiological changes the body goes through when under stress – alarm, resistance and exhaustion. While alarm is the initial phase that results in a panicked, fight-or-flight response, the resistance phase is when our bodies adapt and learn to cope, although the reality is we are masking the symptoms and can find ourselves in a state of denial. This leads to the exhaustion stage if we remain in the elevated stress level for too long.

Petursson said if we view the market as a person and the economic impact of COVID-19 as the source of the stress, the “alarm” was the bear market experienced between February 19 and March 23. 

He said: “Investors panicked as the fight-or-flight response took hold, selling equities into the fastest bear market in history. In fact, according to the Investment Company Institute, March exhibited the greatest selling pressure of equity, balanced, and fixed income mutual funds ever, with US$348 billion redeemed during the month.

“The resistance stage took place as investors became more accepting of the fact that the economic data that would follow the lockdowns were going to be the worst we’ve seen in our lifetimes. Assuming the worst, anything even modestly better than the worst was treated as a reason to bid markets higher. 

“For example, it’s difficult to suggest that the US employment situation is anything but tragic. Investors, however, are more likely focusing on the fact that US first-time jobless claims have declined since the initial bomb of 6.8 million jobless claims the week of March 27 to 1.4 million for the last week of June. Markets are resisting the fact that while this is an improvement, weekly first-time jobless claims have remained above 1 million for the month while continuing claims have stalled out at 19 million for the past three weeks.”

Eventually, this gave way to exhaustion. Struggling with stress for long periods can drain your physical, emotional, and mental resources to the point where your body no longer has strength to fight it. Petursson added: “What we’d imply is that the markets, having staged a very strong and impressive rally, may have to take a breath and reassess.”

His base case, therefore, involves forecasting 18 months ahead rather than the typical 12 because the uncertainty is too great over the next 12 months to build reasonable expectations, pointing to a COVID-19 potential second wave, renewed trade tensions between China and the United States, and the U.S. election.

Petursson said: “If the market is indeed exhibiting general adaptation syndrome, then we would argue we’re about to move into the third phase. However, while the market may experience ‘exhaustion’, we don’t believe it will include a retest of the March lows. Rather, we believe the exhaustion phase will include continued market appreciation and would argue the broad global economy will be accelerating into a recovery. But if you give it all you have in the first mile of a five-mile run, you’re not going to be able to run very fast for the next four.”