The suspense has ended. Finally after two years, the long-overdue market correction began the week of January 29th. Well, at least it did for those of us who define the “market” as the S & P 500. Here’s what you need to know if you’re keeping score: A decline of 10% or more from the market’s most recent high fits the classic description of a correction. A pullback of more than 20% defines a bear market. On February 8th, a mere eight market sessions after the major averages rolled over, the S & P logged a close of 2581. That’s 10.13% off its most recent high. On that same day, the DOW 30 and NASDAQ closed down 8.5% and 7.9%, respectively, off their highs. All the major averages have since moved higher amidst increased volatility. The question to ask: “Did we experience a correction in the market if only a single major average meets the standard?
Rise of the Machines and Fall of the Market
That question is one of many currently being debated by market “experts” of both the fundamental and technical schools of analysis. While we count ourselves among the former, we view technical analysis as a secondary, confirming component of broad market analysis. It’s important to note that bear and bull markets all have beginnings, middles, and ends. Corrections do too. We think the S&P 500 is representative of the broad domestic securities markets and believe the US market correction began on January 29th.
In December, we had been wondering what the catalyst might be that would trigger the next correction. Imagine our surprise that it would be “old news” regarding the Fed’s intent to raise key interest rates in 2018. It was no secret that the Fed was alert to the return of inflation and, in addition to raising rates five times since December 2015, had made the transition from “QE” (Quantitative Easing) to “QT” (Quantitative Tightening) by slowly, and transparently, reducing its balance sheet. Both tools would serve to reel in the massive expansion of liquidity that followed the 2008 financial crisis. So why did the market react so dramatically to old news?
Our theory: Investors already in the market were complacent and not looking to increase their exposure. Those not yet in the market were waiting for a correction as an opportunity to bring cash in from the sidelines. Fifteen consecutive monthly gains, record low volatility, and six straight positive days leading up to the record highs of January 26th intensified the expectation for a correction. All that was needed was a catalyst. That proved to be the Fed’s first statement under newly-seated Chairman Powell. It resurrected talk of as many as four rate increases in 2018, a story that had been trotted out annually by CNBC since 2014 and met by a collective yawn from long-term investors. However, this time short-term technical traders saw that “news” as reason to take profits, moving the averages down to important support levels. Once support was penetrated, the machines took over and raced the market into correction territory in a matter of days.
Where buyers are outnumbered, it doesn’t take long for program trading to turn a run-of–the-mill pullback into a rout. The algorithmic–driven automatons piled on, flash-crash style, to move the S&P down 10+% from its high on February 8th. The program took the S&P 500 into correction territory and then stopped selling. A coincidence? We don’t think so. We believe program trading pushed the market up in January and then back down while long-term investors watched and waited. We’re now left somewhere in the midst of the correction, looking for signs of its end and a launch into the next leg of the bull market. Unlike the pullback, the base-building process is measured in months and weeks rather than days.
New News Clouds the Picture
How long the correction will persist and what its completion will look like are a few of those other questions up for debate. Ironically, a couple of recent events could be deemed legitimate catalysts for the volatility we’re currently enjoying. Last week’s imposition of tariffs on steel and aluminum raises the specter of a trade war where there are no winners in the long run. That, and Gary Cohn’s resulting resignation as the president’s Chief Economic Adviser have the potential to undo some of the positive effects of Tax Reform and reduce confidence and optimism around the global economy going forward. The ultimate outcome from these trade sanctions likely won’t be evident until the renegotiation of NAFTA is complete. Hopefully, the tariffs announced will prove to be only an opening gambit and negotiating tool in achieving parity of terms with our global trading partners, especially those we count among our allies.
Any limitation of free trade is a headwind for the global economy and its markets. The discussion of it is currently focused on the worst-case outcome, a trade war, rather than as a catalyst to review and revamp trade agreements that put the US at a disadvantage. Hopefully, that’s where the discussion will lead us. Volatility is likely to persist as trade issues, the Deficit, and the Fed make headlines. The combination of those have brought about a change to the tone of this market that could extend the consolidation process well into the second quarter and beyond the next earnings season. Investor complacency is long gone, along with any further talk of irrational exuberance.
While traders reveled in the volatility, the brevity of the correction didn’t afford many long-term buyers an investable opportunity. A mere five trading sessions after the low of February 8, we saw the S & P off roughly 6% from its highs. That left those with cash trolling the interest rate-sensitive sectors that spent time in correction territory: Energy, Staples, Utilities, Real Estate, and Telecom. Most of the large-cap favorites in Tech, Consumer Discretionary, and Financials didn’t log a correction and those few that did were there for only a blink of an eye.
While investors are looking ahead to the earnings report parade that kicks off in April, we await the Fed’s meeting of March 20-21 where it’s expected they will raise key rates for the fourth time in a little more than a year. That prospect, coupled with uncertainty over the result of trade negotiations, will likely relegate stocks to a trading range until the correction lows are tested or a consolidation base is built over time. Any positive surprises in those areas, while not anticipated, could propel stocks to new highs and close the book on this correction. There, we would find ourselves speculating once again about whether this bull market has runway ahead or has entered its last stage of euphoria. And the suspense continues.
Conway • Jarvis LLC