The stock market headlines were universally calamitous. The huge single-day selloff was attributed to "worries about economic growth at home and abroad," along with the usual chatter about a slowing Chinese economy according to a CNBC post-mortem. A final trigger was news that Vice President Dick Cheney was an apparent target of a Taliban suicide bombing in Afghanistan….
That last tidbit signals that we are not talking about the 4/15/13 selloff, but the "brutal" selloff on 2/27/07. On that late February day in 2007, the S&P 500 crashed over 50 points, or by 3.5%, from its open at 1,449.37 to a close at 1,399.04. The 2/27/07 selloff was a worse single-day decline than that on Tax Day 2013, when the S&P fell by 36.49 points, or by 2.3%.
If you don't remember the February 2007 crash, you're not alone. It would be an understatement to say there has been a lot of water over the dam since then, most notably the recession of 2008.
In our view, the 2/27/07 selloff provided clues about the coming debacle in autumn 2008. The question for today is -- does the 4/15/13 selloff similarly signal the potential for a broad market decline?
Around that time early in 2007, some eight months before the market peaked, there was concern that the market had come too far and too fast. In rising from 800.73 on 3/11/03, the S&P 500 by 2/26/07 had appreciated 81%, representing a nearly 16% CAGR for those four years.
Investors shrugged off the 2/27/07 crash, buying the dip on the way to a final hurrah for the 2003-07 bull in October 2007. From that close, the S&P 500 would add roughly 165 points to reach its 10/9/07 closing high of 1,565, which stood as the all-time high until April 2013. The fact that investors ignored or immediately forgot that one-day crash was in retrospect a sign that the market had entered that dangerous phase where investors are willing stocks higher and are unwilling to concede that the party might be ending.
The pattern around the 2/27/13 selling is also consistent with a single-sector market, in which the beloved sector that has outperformed the overall market begins to lose its luster on the way to becoming the abhorred sector. In 2007, the single industry pulling much of the economy and market behind was housing. Given that much of the housing activity was around existing home sales and mortgage activity, the sector engine in the 2003-07 bull market was financial services.
For sector analysis, we use the iShares Dow Jones US Financial Sector ETF (IYF) as a proxy. The IYF ETF had risen by 96% from March 2003 to late February 2007. Ironically, this ETF hit its all-time high around 120.00 on 2/19/07, less than two weeks before the one-day crash.
Amid the 3.5% decline in the broad market that day, the Financial Services ETF on 2/27/07 fell a slightly greater 3.75%. Although the broad market rose an additional 11.8% from the February 2007 low to its (then) peak price of 1,565 in October 2007, the IYF ETF basically stood still at the 114.0 level.
The static performance in the Financial Services ETF, at a time when the dying rally was furiously chasing a final 12% of capital appreciation, reflects the disquieting events in summer 2007 and the real precursors to the 2008 market collapse. Late in June 2007, Bear Stearns pledged a collateralized loan of up to $3.2 billion in a failed attempt to shore up two hedge funds heavily invested in collateralized debt obligations (CDOs) largely based on subprime mortgages.
In mid-July 2007, Bear Stearns disclosed that the two subprime hedge funds had lost nearly all their value, underscoring that the market for subprime debt overall had collapsed. From a market standpoint, many professional investors recognized that the crash in CDOs meant that the 2003-07 bull was on its last legs, a lesson many retail investors were not to learn until well into 2008. From an economic perspective, the toppling dominoes from these events would crush book values among the major banks and trigger the recession.
The IYF ETF hit bottom at 24.10 in March 2009, 79% below its February (and October) 2007 level. While financial stocks fared worst of all in the 2008-09 market collapse, the U.S. economy was sufficiently invested in financial services that the entire stock market collapsed. Between the market high of 1,565 in October 2007 and the low of 676 in March 2009, the S&P 500 declined 57% - terrible, but less than the IYF ETF. (For those keeping score, IYF has climbed back to 67.18 as of 4/15/13, which puts it back near its March 2003 level.)
What are the risks that the mini-crash of 4/15/13 contains the same warning signs so blithely ignored on 2/27/07? While the risks are real, we do not believe the corollaries are exact. And we do not see the severe 4/15/13 one-day selloff as a precursor to deeper declines, at least in the intermediate term.
Reasons for our guarded optimism include the diversity of the market advance this time - valuations that do not appear extended, signs of economic expansion, even amid the usual mid-year pause, and an improving domestic environment in which policy impediments have been at least partly cleared. Taking them one at a time, we are most encouraged by the broad nature of the market advance.
As of the mid-April 2013 selloff, our sector tracker shows five sectors - Consumer Discretionary, Consumer Staples, Financials, Healthcare, and Utilities - outperforming the market. Three of these sectors are regarded as defensive (Staples, Utilities, and Healthcare), and two are economy-sensitive (Financials and Discretionary). As we noted a week ago, we would argue that Healthcare is really a "tweener" sector, with economy sensitivity (expressed in consumer healthcare utilization) with a policy "kicker" from reaffirmation of the Affordable Care Act.
The sector laggards, most notably Energy and Materials, reflect sensitivity to the global economy, particularly China. But income-rich Telecom Services is also present in the laggards. Plainly, this is not a single sector market, such as we saw in Technology in the late 1990s heading into the internet-related selloff of 2001-02, or in Financial Services in 2007 heading into the recession.
On valuation, the early 2007 market was already rich on trailing EPS and about to get much more expensive. On a trailing four-quarter basis, S&P 500 operating earnings were $89.40 in 1Q07; and with the S&P 500 at 1,449 immediately post-crash, the index was trading at 16.3-times. At present, the S&P 500 is similarly trading at 16.2-times trailing four-quarter earnings. But earnings in 2007 were heading for a major crash, which became visible later that year as the Financial Services sector collapsed. Currently, earnings are much more balanced and better supported. On our normalized earnings formula, which looks two years forward and three years back, the market multiple is below 15-times.
Signs of economic expansion are a bit murkier, given the usual mid-year pause. The housing economy continues to expand. March housing starts were 1.036 million units at an annualized pace, up 7% month-over-month and up 14% year-over-year. Permits declined month-over-month, but rose 17% year-over-year. Although doubters pointed to the month-over-month decline in single-family starts and disproportionate strength in multi-family starts, the March SAAR (seasonally adjusted annual rate) marked the first time starts surpassed 1 million in 57 months.
There may also be some self-fulfilling aspects of the mid-year pause. Argus believes that seasonal adjustments in economic data, introduced to "normalize" data based on a predictable weather pattern, are in fact distorting reported results given the vagaries of the seasons amid climate turbulence. Based on this topsy-turvy normalization, we are likely digesting reports that over-state strength in winter, followed by reports that similarly under-count activity in spring into summer.
Housing and automotive are the pillars in the recovering consumer economy. Both are highly domestic, and both contribute to jobs creation and overall improvement in the labor economy. A further positive for jobs creation is the relative stability in policy, for the first time since before the recession. The setting of income tax policy and sequestration cuts, which (likely in a good sign) left almost no one happy, now allow consumers and businesses small and large to set their own personal and business agendas. The begrudging acceptance of the Affordable Care Act also clears a final uncertainty from the agenda.
Whenever the market sells off more than 2% in a single session, particularly on sketchy premises, investors should be on alert. When such a selloff happens after a strong multi-year stock run, they should be on high alert. Still, we do not regard the Tax Day 2013 selloff as a sign that this broadly advancing market, underpinned by ongoing economic recovery and rising earnings, is entering its final stages.