Is This the Long Awaited Correction?

As the S&P 500 began to weaken last week, there has been a cacophony of voices declaring that this is The Correction. The questions in a lot of investors’ minds are:

• Are we starting a major correction?
• If so, how far down are we going?

Personally, I believe that the market’s fundamentals were too overstretched for this to be a minor pullback and I concur with the assessment that the bears are taking control of the tape. The tone of the instant euphoria over Thursday's one-day rally of 2% is a contrary bearish signal that this market has further downside in the weeks ahead.

How far down?
Downside targets for the S&P 500 vary wildly. Among technicians, the 920-950 level is often cited as a target, a 10-15% correction. That target level would roughly be the 200-day moving average should the market decline to those levels in the next two or three months.

More bearish types like David Waggoner at Minyanville has suggested that a multi-year top could be in and the “next intermediate level pivot down is around 882”.

Fundamentally oriented investors appear to be more bearish than technicians. Jeremy Grantham’s latest quarterly letter stated that GMO’s fair value on the S&P 500 is 860. Grantham believes that a correction, when it comes, would be at least 15% and would likely overshoot their fair value estimate – which makes downside risk considerable from current levels. David Rosenberg believes that the market is 20% overvalued. By contrast, the market appears even more overvalued if we were to use Tobin Q as a valuation standard.

What to watch for
Trying to guess the downside target here is a mug’s game. I have no idea whether this is a minor pullback or a major correction that could see us test the 666 old lows. I believe that the bears are in control, but here is what I am watching for to see how far the market could decline.

• What is the appetite for risk? Don’t forget that the market’s rally from the March lows has been a risk trade all the way up. It’s hasn’t been just stocks that have been rising, but all risky assets. I would therefore watch all risk measures, such as quality spreads in the bond market. More importantly, I would watch the US Dollar. Art Cashin recently suggested that the USD has been the funding currency for currency carry trades and a big reversal in the greenback could cause over-leveraged hedge funds and trading desks to de-risk in a hurry. If reversals in the Dollar are subdued, then corrective action in the stock market could be subdued as well.
• What about sentiment? In my post A fragile and frothy market, I pointed out that institutions and hedge funds were in a crowded long, but individual investors had been skeptical of the market rally. Watching indicators like the AAII sentiment surveys would be an important sign in the weeks ahead of whether individuals buy on weakness, which would be bullish short term but bearish medium term, or stay cautious, which may portend a more limited correction. If individual investors are convinced that the economy is truly turning around (and never mind the snark) and buy, then it could truly be a sign that we may have seen a multi-year top for the S&P 500.

Comments

[Mad Hedge F...:]

bdr Those of you who heeded my GLOBAL RISK ALERT on October 13missed the top of the market by six trading days and 10 S&P points. I’m sorry; I’ll ring the bell more precisely next time, with a more accurate date and time. Since then, technical sell recommendations have been breaking out like acne at a junior year prom dance. You are all now out of your positions or love them so much that you are willing to carry them through another crash. At the risk of hubris, even PIMCO’s Bill Gross has jumped on the bandwagon, although I doubt he needs my help ascertaining the direction of stocks and bonds. The way everything turned tail and ran at exactly the same time was a complete vindication of my theory that a tsunami of liquidity was raising all boats, completely unjustified by the underlying fundamentals. Long time readers of this letter know the only short I have advocated this year was in long dated Treasury bonds through the TBT. But the better than expected Q3 GDP of 3.5%, obviously fueled by temporary government programs like “cash for clunkers” and the first time homebuyers tax credit, may be presenting one of those pristine, “sell on the news” moments. Will this data finally give us our long awaited double top? Fading rallies in stocks is looking more enticing by the day.

Oct 30 08:49 AM

[JWG:]

Cam,

I don't follow this bit: "If individual investors are convinced that the economy is truly turning around (and never mind the snark) and buy, then it could truly be a sign that we may have seen a multi-year top for the S&P 500."

If the buying broadens (from the pros to the general public) why do you think that would mark a top? I'm either one level of contrary thinking behind you, or you meant "bottom" not top, or...?

Oct 30 09:35 AM

[logicalthought:]

If one thinks (as I do) that Q3 was as good as it gets for a couple of years, but that there's also a chance that Q3 numbers may be sustainable (if not "improvable"), then I think that a "best case" downside scenario is around 900, which would be 15x annualized Q3 run-rate earnings of $60. If we "double-dip" (which I think is a real possibility), we could wind up with a 12x to15x multiple on $45-$50 earnings, which would be 540 to 750. I no longer think that the low end of the latter target is a "high probability scenario" but I do think that it's possible enough that although I currently plan to cover my S&P shorts at around 900, I wouldn't get long the "broad market" until the 600s.

Oct 30 10:51 AM

[Old Trader:]

I might be wrong, but I think Cam refers to the premise that the retail investor is always the last to the party. By way of anecdotal evidence, I got an email from an acquaintance asking me what commodity I'd suggest as a play on his "bearish on the dollar" thesis. It should be noted this guy's a short term trader....NOT an "investor". I wasn't able to be of much help, LOL.


On Oct 30 09:35 AM JWG wrote:

> Cam,
>
> I don't follow this bit: "If individual investors are convinced that
> the economy is truly turning around (and never mind the snark) and
> buy, then it could truly be a sign that we may have seen a multi-year
> top for the S&P 500."
>
> If the buying broadens (from the pros to the general public) why
> do you think that would mark a top? I'm either one level of contrary
> thinking behind you, or you meant "bottom" not top, or...?

Oct 30 11:41 AM

[aldous:]

Long term fundamentals always win out. The market however "can stay irrational longer than you can stay solvent" as Mr Keynes used to say. Europe and USA are on the canvas for the next 5 years and the "China story" will eventually be xposed for wat it is-puny {at present} 4 trillion dollar economy which has been pumped up on steroids of easy credit {About a trillion at last count}, stockpiling of commodities which surely has reached its peak and a govt stimulus program of close to 700 billion dollars. Meanwhile, this exporting economy continues to see its exports down 25%--gee, why arent the de-leveraging Europeans and Americans buying? How does China with a middle class averaging $2000 per capita lead the world to recovery?? The old model of consumption fuelled growth emanating from USA and Europe is broken--its over. Its uncanny how this 2009 rally is fast mirroring the rally of 1932!

Oct 31 05:25 AM

[Spartacuss:]

Of course, the big banks borrowing at zero and rapid trading without risk does throw a bias on all this as they have been into the equities market big time from what I am told. Will they chose to go short now big time and reap even bigger rewards?

This whole market is nothing but an interventionist night mare and I for one wouldn't be surprised at anything, however, I do think the Fed has a plan for equities to shore up pension plans etc., etc. so who knows?

Oct 31 09:01 PM