What Form Will Market Correction Take?

I have written a fair bit over the past few days about the overbought level of most global stock markets and also how China - a leading market on the way up - could be the catalyst for triggering a reversal of fortune. It would seem the expected downward correction is now squarely under way with the MSCI World Index down by 3.4% and the MSCI Emerging Markets Index 5.2% lower since their respective highs of August 13 and August 3.

A summary of the movements of major global stock markets since the recent highs, as well as various other measurement periods, is given in the table below. Interestingly, none of the indices in the table have been able to withstand the downdraught, with the Chinese Shanghai Composite Index (-17.3%) and the Russian Trading System Index (-10.0) leading the way down - in not dissimilar fashion to how these indices blazed a trail to record rally returns of 90.7% and 95.4% respectively.

Click here or on the table below for a larger image.

I have discussed valuation levels and technical sell signals in my recent posts, but another factor that will come into play is seasonality turning negative. Focusing on the S&P 500 Index and the Dow Jones Industrial Index, I have done a short analysis of the historical pattern of monthly returns for these indices from 1957 to mid-2009. The results are summarized in the graph and table below.

Click to enlarge:

Source: Plexus Asset Management (based on data from I-Net Bridge)

If one looks at the average return per month and in which months the most market declines have occurred, it seems as if the months of June, August and September are traditionally bad for stock markets. Although June this year played according to script, with the S&P 500 showing a zero return and the Dow Jones declining by 0.6%, July excelled with 7.4%/8.6% gains. Given the overbought level of markets, it is conceivable that the “bad” months of August and September might conform to the historical pattern. September, specifically, has over time been the month with the lowest average monthly return.

For more about key levels and the most likely short-term direction of the market, Adam Hewison of INO.com prepared another of his popular technical analyses. Although this deals with the Nasdag Composite Index, it is equally applicable to the S& P 500. Click here to access the short presentation.

The much-needed correction of the summer rally could take the form of either a pullback or a consolidation (i.e. ranging). I suspect we may see at least some degree of reversion to the 200-day moving averages in a number of instances, but will be watching closely to ascertain whether we are dealing with a normal short-term correction or a more significant move threatening the primary trend. In the meantime, sit tight and be cautious as markets hopefully realign with the reality on the ground.

Comments

[whidbey:]

Interesting, but how useful? We are not dealing with the ordinary annual calendar of the market.

1. Jobs are falling with no signs of stabilization.
2. Deflation seems to be embedded in the economy (-8% last PPI)
3. the treasury has started spouting silly propaganda
about who is buying what, and for which reasons. Simple fraud.
4. Congress has no apparent intentions of relenting it is quest for more taxes which will in 2010 likely sink the economy (Bush cuts expire and new taxes on the "rich" and god only know what else).
5. The global credit markets seem to what to shift US bond holdings toward the short end of the curve for some reason. Fear?
6. Consumers are not consuming so demand is low and possibly dying. The first stages of a depression (we think).
7. The IMF says the recession is over worldwide. Hooey.

Aug 18 06:07 PM

[Mark Bern:]

Interesting article and graphs, but as whidbey points out in their comment, how useful is the analysis?

Maybe a better assessment would be a survey of investors entering the market over the past six month to determine how long it will take before they come to their senses. The survey could include some startling facts about unemployment, consumer confidence, the number of homeowners now delinquent, expectations for foreclosures in the coming years, and perhaps some information about CRE vacancy rate trends. Then ask them to select as many as desired among those facts that could lead to further deterioration in the U.S. economy.

Of course, the survey would need another section for listing reasons that the economy will recover with all the above factors along with an additional box for "other" and they would all probably fill in "Stimulus." In the comments section they would write, "the Stimulus package and possibly others to follow will save the economy because the recession is over. I heard it on TV!"

Aug 18 06:53 PM

[Roger Knights:]

The top is in: the cover story of Business Week's Monday special issue is, "The Case for Optimism."

Aug 18 06:54 PM

[Kimball Corson:]

Asking how big the correction will be, assumes there will be a correction. Of course, there is always a significant correction in the future. The real question then is when. One of Ferrell's rules of investing is fast rising markets go further up than you think they will. So again, the only real question is when are we going to get a correction we should have acted upon.

Aug 18 07:11 PM

[j-dub:]

A correction whose form looks kind o flike a world war.
With fundamental analytics on one side selling the bloatedness that is the S and P to preserve any and all capital vs. the PPT fighting like hell to keep this pig propped up in order to perpetuate the mirage.

What a battle

Aug 18 09:08 PM

[David Van K...:]

Here, I'll give you all something to mark thumbs-down:

--People who entered the market in the last six months did not take leave of their senses: They are up 45% or so. Where are you?
--Any economic cycle must slow down and reach a turning point before it starts back in the other direction. The economic cycle--with all the bad data points--has truly been going down, but at a slowing rate for several months now. That is not inconsistent with the fact that it could, in fact, be turning around. In fact, it is consistent with it.
--If you want to model that the economy will go into a double-dip recession or just never make it back to even, just keep getting worse, state your thesis and relate it to the market's likely response.
--The stock market is forward-looking. It often rallies during an economic contraction, in anticipation of economic reversal. It has done so in 8 of the last 9 recessions. (Oops--this current one makes it 9 out of 10. Can we all agree that +45% in 5 months is a rally?)
--On the survey, government stimulus is a valid answer, laugh at it as you might.

I am not saying that the market will continue to rally from here. It may well correct and then rally, or it could drop streadily, it could go up and down (sideways) for a period, or it could take off in a burst upward, as it did in July just as all the technicians were convinced it was doomed because the "right shoulder of the perfect head-and-shoulders formation" had broken downward. That lasted all of one day. The market ended up 5% for the month, and nobody talks about the head-and-shoulders formation any more.

I, too, worry about the negative economic overhangs on the market. But the market does what it does, and the fact is that any model that predicted the rally over the past 5+ months is the winning model at the moment. All the other ones, logical as they might have sounded, were wrong. Theory does not triumph over returns...it's the other way around.

Prieur, lots of interesting data. In your last paragraph, what's the "primary trend" you refer to? Up or down? Over what time frame? Without defining your terms, I can't tell what you are saying. Why is a correction "much needed"? According to the latest charts (RSI), the market is not overbought anymore.

Aug 18 10:08 PM

[User 250263:]

r u saying people buying stocks up in xmas?

Aug 19 04:08 AM

[Schweizer:]

We already know what Form the Market Correction will take because we got the correction already, from early March to early August. Like the same 52% correction that occured in 1930, this one will roll over and slide towards the March lows, without much turning back, and will ultimately go lower.

Why? Nothing has been fixed, and the PE on SP500 is over 3 on a 2009 GAAP earnings basis. All the major bear market bottoms this century were acheived with a PE under 10.

The $SSEC (China) is about 2 weeks ahead of the SP500 on this journey to new lows. It has already broken its 50dma and its uptrend line after correcting to the 38.2% Fib line from the top.

Chart:
i31.tinypic.com/2eezdw...

Aug 19 05:41 AM

[Schweizer:]

CORRECTION. Should read "PE on SP500 is over 30"


On Aug 19 05:41 AM Schweizer wrote:

> We already know what Form the Market Correction will take because
> we got the correction already, from early March to early August.
> Like the same 52% correction that occured in 1930, this one will
> roll over and slide towards the March lows, without much turning
> back, and will ultimately go lower.
>
> Why? Nothing has been fixed, and the PE on SP500 is over 3 on a 2009
> GAAP earnings basis. All the major bear market bottoms this century
> were acheived with a PE under 10.
>
> The $SSEC (China) is about 2 weeks ahead of the SP500 on this journey
> to new lows. It has already broken its 50dma and its uptrend line
> after correcting to the 38.2% Fib line from the top.
>
> Chart:
> i31.tinypic.com/2eezdw...

Aug 19 05:43 AM

[Alphameister:]

Love the comment by David Van K. This "greater fool" is up roughly 100% ytd by focusing on Chinese stocks, down 9% from my highs despite being hedged, and expecting further substantial gains from GARP opportunities that seem more characteristic of a market low than a market peak (though the Business Week cover is indeed a very troubling indicator).

It is not always a great advantage to be able to see reality better than the market sees it. And the investor totally convinced he knows more than the market is often the "greater fool." (Been there, done that more times than I care to admit.)

Aug 19 01:35 PM