Market Extra: Why the stock market might not bottom until investors surrender and jump back into bonds

Stocks were adding to losses Thursday, with the S&P 500 down 0.6%, while the Dow Jones Industrial Average
DJIA
declined 145 points, or 0.4%, after turning negative for the year earlier this week.

As would be expected, the stock market slump has left investors increasingly pessimistic about equities. Extreme pessimism can be a contrarian indicator, and the investor mood is now at a level that’s typically preceded strong stock-market gains, noted strategists Ed Clissold and London Stockton of Ned Davis Research, in a Wednesday research note.

Since 1994, the S&P 500 has risen at a 26.7% annual rate when NDR’s Daily Trading
Sentiment Composite has been in its extreme pessimism zone, they noted.

But the outlook is complicated by the Treasury market rout, with investors — unsurprisingly, given the scope of the fall — even more pessimistic toward fixed income, according to NDR’s proprietary indicators. Treasury bond futures
TY00,
+0.15%
dropped around 17.5% from their April 6 high through midweek.

The NDR Daily Bond Sentiment Composite is also at its lowest level since March and deep into its extreme pessimism zone, they wrote, consistent with a 4.8% annualized gain by T-bond futures.

What’s more, simultaneous tumbles by stocks and bonds have been rare, though investors of course have fresh memories of the 2022 rout that decimated traditional portfolios split 60%/40% between the two asset classes.

Blame it on inflation. Clissold, in a phone interview, noted that for much of the past quarter-century, stocks and bond prices moved opposite each other. Or, stocks tended to rise as Treasury yields rose.

It was a different story before the early 1990s, when rising yields tended to accompany weakness in stocks. Then, as now, rising yields signaled the Federal Reserve would need to step in to fight inflation. In the more recent past, rising long-term yields were seen as bullish for stocks because it indicated deflationary forces were becoming less powerful, Clissold said.

Clissold and Stockton observed that when investors are more pessimistic toward bonds than stocks, as they are now, bonds have tended to outperform.

That points to two likely scenarios, they said.

In one possible chain of events, anxiety around both stocks and bonds “turns into a full risk-off environment, where Treasury bonds rally while stocks continue to correct. Perhaps that would be part of a capitulation that leads to a year-end rally in the stock market,” Clissold and Stockton wrote.

The stock-market selloff so far hasn’t been a “capitulation-type of event where the decline turns into a panic,” Clissold told MarketWatch. The retreat has been fairly “ordinary and broad-based” by historical standards, with the Cboe Volatility Index
VIX
rising but not hitting extremes and the S&P 500 not suffering a number of outsize down days.

An event where investors go “completely risk off” would see Treasurys rally on haven-related demand, pulling down yields and relieving the sentiment differential between equities and bonds, he said. It would also see the stock market fall to the type of very deeply oversold conditions that would be expected to lead to a rally.

Analysts at Barclays on Wednesday argued that a deeper stock-market selloff would be required to turn the tide in the bond market.

See: ‘No magic level’: Yields won’t cool without ‘substantial’ stock selloff, says Barclays

That’s not the only way the situation could resolve itself, however.

In another scenario, both stocks and bonds could simply rally together, albeit with bonds outperforming, Clissold said.

In the end, the market will tell the tale.