The markets dropped alarmingly on Monday and Tuesday as investors worried about the economic impact of the COVID-19 outbreak, which has now prompted the Centers for Disease Control and Prevention (CDC) in the U.S. to implement planning for a possible pandemic.

By the close on Tuesday, the S&P 500 had dropped more than 7%, which is technically in bearish correction territory.

As we have been saying for a few months, the market is still bullish, but there have been some serious weaknesses that prompted us to be very cautious about how much risk we were exposed to in our portfolio.

This week’s volatility isn’t entirely unexpected. One of the key warnings we discussed at the beginning of February was that long-term Treasury yields were dropping while large-cap stocks were rising.

Keeping Volatility in Perspective

As you can see in the following chart of the CBOE 10-Year Treasury Note Yield Index, the yield on 10-year Treasurys has hit a new low as investors sell stocks. These two asset classes tend to move together when the market is confident.

Daily Chart of CBOE 10-Year Treasury Note Yield Index (TNX) — Chart Source: TradingView

The issue with signals like this is that they aren’t great timing indicators. Instead, they imply that if there is selling in the market, it is more likely to lead to a small panic than if the market weren’t expressing signs of stress.

Therefore, when a catalyst like the COVID-19 outbreak appears, it can trigger the “weak hands” to sell quickly, and the market enters a negative correction.

It’s true that the selling triggered by the coronavirus outbreak has exceeded our expectations, but this isn’t a unique situation historically.

Over the past 10 years, there have been 78 one-day declines that exceeded 2% — and over 75% of those instances were followed by positive returns over the next month. So, we should be careful about getting too bearish too soon.

Further, we have observed that when a selloff drops the S&P 500 to a key support or pivot level, the likelihood of a bounce over the next 30 days is even higher. Unfortunately, we think it’s unlikely that the current level is that pivot point, so the S&P 500 could drop further before finding support.

As you can see in the following chart, if there is more selling, the nearest firm level of support on the S&P 500 is 3,020, or 10% below the highs. That’s bad, but it would still only be half the decline that we saw in the fourth quarter of 2018 or the third quarter of 2011. While the current disruption is frustrating, it isn’t worse than what we have already experienced — and profited from shortly after — during the bull market.

Daily Chart of the S&P 500 — Chart Source: TradingView

Being a bull when everyone else is terrified is usually a pretty good strategy, so we are still maintaining our positive bias in light of the volatility. However, we will adjust our approach a little, and we will make more changes as needed.

In particular, the risk of a worsening outbreak is concentrated in the retail sector. This is especially true for Asia and Europe but will likely affect the U.S. as well. Consumers in countries with quarantines will spend less, and if production in China slows, consumers in other countries won’t have as many products to buy.

As you have heard us say many times, the engine of developed economies is the consumer, so any further weakness will be a big problem for the major stock averages.

The issue with consumer spending may help explain why the banks and credit card companies have dropped so much this week. Mastercard (NYSE:MA) was down nearly 7% on Tuesday, largely driven by concerns about spending.

Interestingly, investors haven’t hammered discount retailers like Target (NYSE:TGT) as much, which we think is a signal that some of this week’s selling is overblown.

Is There a Risk of a Long-Term Impact?

What is happening in the market on any given day is not a response to the present but a reaction to what investors think the future will be. So, although the news about the coronavirus is bad, the selling reflects investors’ concerns about earnings and market fundamentals over the next six to nine months.

Historically, investors have usually overshot bad news, which give us an opportunity to get a lot more bullish in the short term.

It is true that if the outbreak continues to worsen and retail spending trends turn negative, the long-term impact on retail stocks would be severe. However, we don’t know yet whether that will happen.

The same thing is true of the transportation, banking and manufacturing sectors where the exposure is very similar. We won’t have many hard numbers until earnings season begins again in April which is probably too long to wait if we need to make changes to the overall strategy.

Our plan is to watch three key technical levels on the major indexes as early warning signals that the “correction” could turn into a bear market.

1. The S&P 500 has solid support in the 3,020 range. If prices drop that far, it should be a good buying opportunity. If the index falls too far below that, we would need to evaluate our cautiously bullish stance.
2. The Russell 2000 small-cap index has already broken its key pivot point in the 1,590 range, which means a break of secondary support at 1,520 would be a trigger for a more bearish stance.
3. Bond yields are at record lows, so anything other than a quick rebound or flat-basing pattern over the next week has to be seen as a serious sign of weakness.

The Bottom Line

We are waiting to see if the market confirms a bottom this week. Because the selling is within historical norms so far, we aren’t overly concerned, and we plan to leverage our income strategy on any short-term support bounces.

In the meantime, some of our covered call positions could lose enough value for us to roll them out for more income. Ideally, we would like to do that in two stages. First, we would close the short calls that are open — as the opportunities present themselves — and then we would sell calls again on a bounce.

If the major technical levels we are watching do not hold, our tentative plan would be to sell into the weakness with some short positions in sensitive sectors like brokerage, insurance, manufacturing and basic materials.

For now, we suggest remaining alert and cautious. Keep in mind how well we did after the last few rounds of selling over the last few years. If we can identify a bottom in the short term, we want to take advantage of that.

John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it. John & Wade do not own the aforementioned securities.