How to Play a Market Pullback

Stock markets might just have finished a particularly strong quarter - with the S&P 500 Index gaining 15.2% for its best quarter since 1998, the MSCI World Index rising by 19.7% and the MSCI Emerging Markets Index adding 33.6% - but started to look tired last month, and July is also off to a shaky start.

Volume has been declining on rally days and expanding on declining days, which can be construed as bearish action. On July 2, Lowry’s Buying Power Index closed one point below where the Index was at the March 9 stock market lows, i.e. Buying Power is now weaker than it was at the early March bottom.

As doubts persist over the strength of the global economic recovery, the S&P 500 Index, MSCI World Index (ACWI) and MSCI Emerging Markets Index (EET) have dropped by 5.0%, 5.9% and 6.3% respectively from their June highs.

Regarding the US markets, an excellent contrary indicator worth keeping an eye on is the CBOE Volatility (VIX) Index. The Index peaked at 52.7% in early March, coinciding with the rally lows, and has since declined by more than half. However, the Index seems to be bouncing off a support line while the Commodity Channel Index (CCI) - a momentum-type oscillator - has turned up from an oversold level for the first time since last May. This would indicate the end of the stock market rally.

Click to enlarge:

Source: StockCharts.com

Considering the percentage of global stock markets trading above their 50- and 200-day lines respectively makes for interesting analysis. Most countries (89%) are trading above the 200-day average - an indicator of a bullish primary trend. As far as the secondary trend is concerned, 55% of the countries are still trading above the 50-day average, having corrected from an overbought level of 100% a few weeks ago. One would typically expect this measure to decline to lower levels in order to more fully correct the massive spring rally.

David Rosenberg, chief economist and strategist of Gluskin Sheff & Associates, said:

...For the near-term … the testing process [for the S&P 500] does seem to be in place right now and carries with it some well-established investment patterns. Over the last year, we have seen four other testing phases and they all failed as the market did break to new lows. With the proviso that the S&P 500 hit an interim peak of 946 back on June 12, here is what the recent historical record tells us to expect (at a minimum, take profits).

-The average length of the testing phase is 53 calendar days and 38 business days (versus 45 calendar days and 33 business days for the interim bear market rallies).

-On average, the S&P 500 undergoes a correction of more than 20%.

The sectors that led during the rally, corrected most during the sell-off; this means that financials, consumer discretionary, materials and industrials; should underperform in the next few months, while health-care, consumer staples, utilities and telecom services should emerge as the leaders.

- Market volatility more than doubles, on average.

- Bonds rally, with the 10-year Treasury note yield down nearly 15 basis points, on average.

- The flight to safety during these periods implies that the Canadian dollar declines (on average by 10%), while the trade-weighed U.S. dollar rallies by more than 6%.

- Commodity prices decline by an average of 15%, again as cyclical trades unwind.

- Corporate spreads (Baa) widen by an average of more than 60 basis points; it is very important to be focused on high-quality paper during these market-testing periods as high-yield spreads widen, on average, by more than 300 basis points (and keep in mind the vast outperformance, which is typical during bear market rallies).

- What we discovered during this process was that gold performed quite well during both the bear market rallies and the subsequent selloffs (and despite the flows back in the U.S. dollar). This may be an indication that gold is in a secular bull market.

Rosenberg concludes:

We found that health care, staples, utilities, high-quality bonds and the U.S. dollar work best during these retests.

Meanwhile, Teun Draaisma, highly-regarded equity strategist at Morgan Stanley, argued there are “plenty of opportunities to make money beyond the market direction call” by pursuing a strategy that he describes as “the middle ground”, as reported by the Financial Times.

Macro and the next big market move have become everyone’s favorite investment topic over the past two years. We suspect it is time to move on to the micro of sectors, stocks and styles.

Draaisma’s large “middle ground” of investment opportunities include “the forgotten market” Japan and “sectors that are cheap and under-owned with improving fundamentals” such as utilities, telcos and energy. Also

Buying stocks with a management change, financial restructuring or a change of focus can be very lucrative.

I said the following on Sunday in my “Words from the Wise” review:

In my opinion, US stock markets are mapping out a base development formation, whereas a number of emerging markets have already bottomed out and subsequently confirmed primary uptrends. However, in the short term it is quite likely that markets could consolidate further and possibly retrace more of the prior gains.

While investors wait for Mr Market to show his hand, a cautious approach is warranted but that should not preclude one from finding stocks that look cheap.

Comments

[CautiousInv...:]

This is a most informative article, highlighting the challenges of investing when the market gets ahead of itself in a very complex economic environment.

"The sectors that led during the rally, corrected most during the sell-off; this means that financials, consumer discretionary, materials and industrials; should underperform in the next few months, while health-care, consumer staples, utilities and telecom services should emerge as the leaders."

This anticipated sector rotation corresponds with classical patterns of the past in which materials, industrials, consumer discretionary and financials start advancing at the trough of ISM surveys in anticipation of economic recovery.

In today's market, though, we have a situation in which the ISM data has bottomed but the economic recovery is being questioned and reexamined in the light of much doubt. Unlike previous cycles in which the uptick comes immediately after the bottom, we may crawl along the bottom until needed structural changes take place and consumer balance sheets are repaired. This could take several years and there will be other challenges along the way.

The likely course in the immediate future, though, is exactly what the author lays out.

Jul 07 08:04 AM

[Larry House:]

The title should be "No One Knows What to Do Now," which is what the article explains. I certainly agree with patience and caution for a while.

Jul 07 11:58 AM

[Peter Cooper:]

I agree there is time to sit-on-the-fence for a little while at this point but there is still enough optimism around for a final spike higher - and then we are set up for a big fall in the fall as reality bites back, see: arabianmoney.net/2009/.../
Some commentators think inflation might rescue stocks from a big tumble - but I do not see any inflation in my life at the moment, on the contrary we are in a period of deflation right now.

Jul 08 02:00 AM

[markfl:]

"For the near-term … the testing process [for the S&P 500] does seem to be in place right now and carries with it some well-established investment patterns. Over the last year, we have seen four other testing phases and they all failed as the market did break to new lows. With the proviso that the S&P 500 hit an interim peak of 946 back on June 12, here is what the recent historical record tells us to expect (at a minimum, take profits)."

What are the prospects for support on the S&P at 900, say beyond Aug. 6? Right now the B L S employment release is the only indicator I can could consider a recovery signal.

Jul 08 07:45 AM

[markfl:]

I should correct myself. .IPX fell on the July 3rd employment data. At this point a recovery, if here, should start to show itself with labor output. Weekly work hours have been falling by tenths of an hour during this S&P rally. If the Aug. report is negative again, arguments for the index going lower take on added weight. NBER says the recession started in '07, but it took them a year to make the official call. It took two years for them to officially announce the end of the 2001 recession because it took that long to be sure it was REALLY over. Jobs were really weak all through 2002. We may have the same setup again in 2010.

I have one S&P stock I'm looking at. No position yet, but if it bottoms I may go long in Sept. I just don't know yet. I'm only looking at tech. right now.

On Jul 08 07:45 AM markfl wrote:

> "For the near-term … the testing process [for the S&P 500] does
> seem to be in place right now and carries with it some well-established
> investment patterns. Over the last year, we have seen four other
> testing phases and they all failed as the market did break to new
> lows. With the proviso that the S&P 500 hit an interim peak of
> 946 back on June 12, here is what the recent historical record tells
> us to expect (at a minimum, take profits)."
>
> What are the prospects for support on the S&P at 900, say beyond
> Aug. 6? Right now the B L S employment release is the only indicator
> I can could consider a recovery signal.

Jul 08 09:27 PM