May Melee Most Likely a Correction

Includes: DIA, IWM, QQQ, SMH, SPY
by: Alan Brochstein, CFA

Markets run in cycles. The past year has been a very tough one to label because the bear market from 2007-2009 was so brutal. I went on the record in January and stated that we were still in a bear market. I set up a "line in the sand" of 1229 on the S&P 500, pointing that it was the 61.8% retracement level from the 2007 high to the 2009 low. For those who don't appreciate Fibonacci as much as I do, it also served as a key support level several times in 2008 before the big plunge as well as an area of support and resistance at various times in 2005-2007.

I followed up with one of my most read articles ever on Seeking Alpha in February, during the "almost" correction, with a prediction that this would be a year for the stock-pickers, finally, rather than just a market-directional year. I continued my constructive short-term view as we approached my "line in the sand" in mid-March, sharing a warning that we could be running out of gas in coming weeks:

The Ides of March is upon us, but it seems like there is no reason to beware. Bears have been head-faked and otherwise bullied about by a market that just won't quit. I continue to expect that the objective I laid out earlier this year of the S&P 500 testing 1200-1230 is likely to be achieved in the next few weeks. It's not that heroic a call, as it represents just another 5-7%.

The market peaked in late April, just a bit later than I expected, but precisely in the range I had projected (intraday high was 1219.80 on 4/26). I admitted in March that I was "clueless" as to how far the market might correct, but I expected that it would be at least 10%. Thus far, from the peak to the intraday low Tuesday, the market pulled back a stunning 14.7% in just 30 days. Scary, indeed, as we never experienced even a 10% retreat in the last bull market. Is this the resumption of a bear market?

As I have struggled over the past year to "get on board" the notion that we are in a bull market rather than a bear market rally, I have been describing the market as "transitional". I did a much better job at the end of the bear market in 2002 with my outlook, recognizing in March 2003 that we were in a bull market. This time, while I was optimistic about a bounce only in February of 2009 (painfully premature), I fought the tape from May through October, expecting a pullback that never came. I continue to expect that we actually did have a "V" bottom that will sustain a longer-term bull market in stocks (though not one like the good old days of the 1990s!), but I do have considerable respect for the many problems our economy faces (though believe that they are widely known and incorporated into the current pricing). I would argue that most companies have really improved themselves operationally and financially in facing the recent adversity, but that isn't really what I want to address today.

While it's too early to call definitively what this market is (resumption of a bear, consolidation of a bull), I want to share mainly my technical views. For those who follow my work, you know that I am primarily a stock-picker, but I do spend considerable time trying to understand the investment climate. I believe that stocks ultimately follow earnings and are priced to compete with prevailing interest rates (corporate bonds, ultimately). Earnings are improving and should continue to do so in my opinion. The overall valuation of stocks in general (call it 15PE) is extremely generous to the current long-term corporate bond-rate (call it about 6%). The biggest concern that folks seem to have these days is that federal debt is growing out of control (and it is!), but I would point out that overall debt is growing slower than the economy. Can that be? What's happening is that Consumer and Business Debt are shrinking. So, before I go into my technical approach, let me conclude that valuation and fundamentals seem ok to me.

I don't blame people for feeling a bit cautious right now. The "flash crash" earlier this month didn't exactly inspire confidence in the structure of the market, and clearly headlines regarding Europe are frightening. Companies sound cautiously optimistic, but they didn't exactly anticipate the complete collapse in their businesses in 2008/09. If one looks at the recent price action, it looks potentially very toppy:

Spx ytd At this point, I want to test the thesis that this was just a bear market rally. To do so, first I want to define "how low it can go". Second, I want to see if there are any signs within the market that suggest the broader market might follow. Before answering those questions, though, I want to point out that the very high volume in May is suggestive to me that the action was just a correction that kicked in once the January highs of 1150 were violated.

While I would like to say that the lows are in, with the February trough essentially holding last week, I am not so sure. Breaking them is quite possible, but not necessarily technically important from my perspective. I get scared when I see a pattern developing of "lower highs and lower lows". Without a rally up out of this sharp one-month downtrend line, new lows will be only "lower lows on higher highs". I am looking at a monthly chart for this perspective. We clearly had a high in January, a low in February, a new high in April and are in this downward move now. Support would appear to be between 980 and 1030 (my read - happy to explain if anyone is curious), which would represent a total decline from the peak of 16-20%. Many define the 20% threshold as a defintion of a bear market, so it gets interesting down there. When I look at the Fibonacci retracement potential, I think that the market could pull back to as low as 877 before we would bury the corpse, as that's a 61.8% retracement of the bull run. I don't know about you, but I am not sticking around that long! More likely, we might find support between 943 and 1008, the 38.2% and 50% retracements respectively. So, unfortunately, we can still go down a bit before this begins to look like a bear market. If I am correct about what I envision as a potential downside of 980-1010, the year-over-year change in the market will remain positive over the summer.

The overall market is trending higher in terms of the direction of its long-term moving averages, though we are trading below currently. For those who recall the pain of two years ago, moving averages were in decline. What about the components of the market? Do ANY of them look like they are declining? Here is my read of the major sectors (in order of the GICS system):

  • Energy: One of the weakest parts of the market, but hasn't turned the 200dma, only flattened it. Strong support is 5-10% beneath here. Trading below Feb. lows
  • Materials: Similar (due the dollar strength), but not as negative. Closer to support than Energy
  • Industrials: VERY encouraging - nowhere close to Feb lows, this market leader is clearly in an uptrend. Weakness here would be of concern.
  • Consumer Discretionary: Ditto
  • Consumer Staples: No safe haven, that's for sure, with a flattening 200dma, but not bearish
  • Healthcare: I addressed this last week - quite ugly, but flattening 200dma only but a horrible eclipse of the February lows. Note that the sector didn't make a new high in April
  • Financials: Decline has pushed it back into a very solid trading range that has existed most of the past year
  • Technology: Quite similar to Materials
  • Telecom Services: Very ugly - have been all year. Still close to the 2009 lows! Not a big part of the market (VZ, T)
  • Utilities: Sector never confirmed highs - peaked in December actually. Again, a very small part of the market but looks consolidative to me

Looking at the sectors, then, we see some areas of concern, but nothing that suggests a resumption of the bear market. Not a single sector has moved to "flat" over the past year. Clearly, the leading sectors remain in good shape - Consumer Discretionary and Industrials. The weakest areas have generally been weak: Healthcare, Telecom Services, Utilities. The latter don't have cyclical exposure. Energy, which we have avoided all year in the Top 20 Model Portfolio, is one we need to watch, but I think it is mainly a function of being overpriced initially and now hurt by the dollar and regulatory concerns. In fact, regulatory concerns are quickly becoming risk-factor number one across the market it appears.

Take a look at individual stock charts, and I think you will also see that the vast majority of stocks are in corrective mode at this point. If we start to see some of the charts from the largest companies look scary, we should get concerned. General Electric (NYSE:GE) is a great starting point. If that gets scary again, then I get scared. One area of the market that has often served as a good overall barometer is the high-beta semiconductor sector. SMH, which is heavily influenced by Intel (NASDAQ:INTC), looks promising in my view.

I have been hearing or reading that many expect us to go sideways for the summer. I will be surprised. My expectation, despite my recognition that we could dip first below the recent lows as I described, is that the market will be at 1150 again by the end of the quarter or at least by earnings season in late July. My best guess is that we make new highs later this year, though I am not so sure that we hold them for the balance of the year. As I originally predicted in February, this year is not likely to have a huge move one way or the other. The most likely catalyst for this rally I envision, that clearly defines the market as a bull, is the dollar. It can now weaken a lot without raising fears of inflation. As always, I will be cautious if we start to see pressure on the 10yr Treasury, though that's probably 100 bps away before it becomes worrisome.

So, that's my story, and I am sticking to it. Market timing is always challenging. As I look at individual stocks, I find tons of great opportunities, even if they might get a little more attractive in the short-term. My Conservative Growth/Balanced Model Portfolio, which seeks to beat the combination of 60% stocks and 40% bonds in an up-market and to hopefully preserve capital in a down-market, is fully invested in stocks at its maximum 75% now after some adds in May. This is largely a recognition that large-caps and low-beta sectors are very cheap, though we aren't exclusively large-cap in the model. The 16 names are represented heavily by Consumer Staples and Health (4 of each), but we also have exposure to Consumer Discretionary (2), Financials (1), Industrials (2), Technology (1) and Utilities (2). The 16 stocks have a dividend yield of 2.6%, which is higher than the S&P 500, and a forward PE of 14, which is similar to the market. 10 of the 16 have net cash on the balance sheet, so we are playing it pretty safe on that front.

In closing, I will repeat my advice from early February:

I think that this market will reward hard work in the trenches. It's probably best to focus in areas where others don't, so that probably means smaller names and more of a value orientation or GARP rather than aggressive growth. As the global economy remains challenged, we should continue to focus on companies with better balance sheets. My guess is that the kind of market I envision will require us to be more opportunistic than normal, taking profits when they arise and jumping into herd selling situations. I certainly don't have a crystal ball about whether or not the market rally from the lows last March continues all year, but I am confident that there are plenty of opportunities for those willing to do the work.

With small-cap value (Russell 2000) up 7.77% YTD now and large-cap growth (S&P 500) down 3.43%, this advice is working so far, and I expect the trends to persist.

Disclosure: No positions in any stock mentioned