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Taking the Temperature of the Market

There is no shortage of indicators used by investors to gauge where the market is going in the short term but many are unreliable at best, and the ones that are attested usually get arbitraged out over time. In our last note we mentioned that historically when the market enters bear territory we are closer to the end of a drawdown rather than a beginning. But the selloff so far this year has been relatively orderly. The VIX, also known as the “fear gauge” is an index which uses S&P 500 options pricing to derive the expected volatility of the overall market. When the VIX is high that usually indicates that there is an elevated level of fear among investors signaling the market may be near a low. This low in the market typically coincides with a spike in the VIX above 40 which we have yet to see but will likely be one of the more nimble signals that the market selloff has finally bottomed. 

Additionally in past notes we outlined how valuation metrics are a fundamental tool for measuring the attractiveness of the market. The S&P 500 now trades at a 15.5x forward price/earnings multiple, in line with its 15 year historical average. But the “Earnings” part of that equation is at risk of being revised lower as company results come in below estimates. Also, corporate earnings estimates can be more of a lagging indicator than a leading one, especially during cycle pivots. The S&P 500 bottomed 105 days before earnings bottomed in 1990, 295 days after during the Tech Bubble, 51 days before during GFC, and 66 days before during COVID.

A more reliable leading indicator for corporate earnings are business surveys such as the ISM Manufacturing Index, also known as the purchasing managers index (PMI). This index is a monthly survey of economic activity based on the largest manufacturing firms in the country and indicates the level of demand for upstream products and overall business confidence. In 19 of the 21 market corrections since 1950, leading indicators such as the PMI have bottomed before markets rebounded. Using projections based on short-term rates, global bond yields, and commodity price action these point to a modest recalibration in the PMI which should correspond with earnings estimates also being revised down. Subsequently, once the PMI bottoms out this should signal that earnings have troughed and the market will follow. The chart above shows the strong correlation between year-over-year performance of the manufacturing index and performance of the S&P 500.

I called this “taking the temperature” but gauging market sentiment is more of an art than a science. At the end of the day capital markets are not static entities so navigating them is a process. Still, we wanted to show what we are watching as we progress through this period of volatility and how we are thinking about the current positioning of the market. As always we are happy to discuss.

Commentary Disclosures: Covington Investment Advisors, Inc. prepared this material for informational purposes only and is not an offer or solicitation to buy or sell. The information provided is for general guidance and is not a personal recommendation for any particular investor or client and does not take into account the financial, investment or other objectives or needs of a particular investor or client. Clients and investors should consider other factors in making their investment decision while taking into account the current market environment.

Covington Investment Advisors, Inc. uses reasonable efforts to obtain information from sources which it believes to be reliable. Any comments and opinions made in this correspondence are subject to change without notice. Past performance is no indication of future results.


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