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Summary

  • Stocks endured another round of volatility this week, including a sharp sell-off on Thursday and Friday.
  • The latest pullback in stocks raises some natural questions.
  • Is this the beginning of a sustained correction, or is this just another pullback and a good buying opportunity?

Stocks endured another round of eventful trading this week. After reaching new all-time highs to start off the new quarter, stocks entered into a suddenly sharp descent last Friday, and have been moving lower in fits and starts over the several days since. And by the close of trading this Friday, stocks, as measured by the S&P 500 Index, were once again in negative territory for the year. This latest bout of pressure raises the natural questions. Are stocks finally entering a sustained corrective phase? Or is this just another pullback in the ongoing bull market rise?

A Correction Is Long Overdue

The fact that U.S. stocks are falling at all in early 2014 should not come as a surprise to investors. For since the correction during the late summer and early fall of 2011, U.S. stocks have been flying higher, while the rest of the world has largely languished, including emerging markets (NYSEARCA:EEM) and commodities (NYSEARCA:DBC). While a few developed international markets (NYSEARCA:EFA), such as Japan (NYSEARCA:EWJ), Germany (NYSEARCA:EWG) and a handful of other European countries finally started to track the U.S. to the upside early last year, the U.S. has still managed to widen the outperformance gap over this time period.

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The foundations behind the U.S. stock market advance are also rather wobbly. Those that are more optimistic might look at the above chart and claim that the U.S. is right and other global markets are overdue to catch up. Hopefully, this is correct. But what is disconcerting in this regard is that nearly the entire advance in the U.S. stock market since late 2011 has come as a result of valuation multiple expansion. For example, the as reported P/E ratio on the S&P 500 at the market lows in early October 2011 was 13 times. Today, it is nearly 18 times and explains nearly all of the stock market advance during this period, as corporate revenue and earnings growth has generally stalled over this same time. All of this, coupled with the fact that the Fed's QE3 stimulus program that has provided tremendous support to U.S. stock prices since the beginning of 2013 is now currently in the process of being completely wound down by later in the year, and one does not have to search too deeply to identify reasons why U.S. stocks may be under pressure to the downside today and in the months ahead.

The Stock Uptrend Remains Intact, Despite Fundamental Weakness

The uptrend in U.S. stock prices remains intact, despite strong fundamental justification for the latest sell-off. And this fact must be respected, as the stock market has made a practice of shredding short sellers that have moved too early to try and capitalize on a downside shift. Making matters even more complicated, recent history has also shown that even if stocks begin to confirm that a downside move is underway, all it has taken is little more than a wink and a nod from a member of the Federal Reserve, and suddenly, stocks are exploding to the upside once again.

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Several key points are worth noting in the wake of this latest sell-off.

First, stocks are only down roughly -2% for the week and less than -4% from their all-time intraday high last Friday after the employment report. Moreover, while Thursday's decline of -39 points on the S&P 500 Index looked fairly dramatic on a headline basis, the move was simply a give back of the strong +26 point rally that took place the previous two days on Tuesday and Wednesday of this week. Thus, while the decline to end the week has felt dramatic, it is still fairly small so far from a broader perspective.

Second, stocks continue to hold above a variety of critical support levels. To begin with, the S&P 500 battled on Friday to hold support at its upward sloping 100-day moving average at 1828, which is a level that has provided reliable support on three separate occasions over the past year. And even if the S&P 500 breaks this support, which appears likely, the next level is the upward sloping 150-day moving average, currently at 1793. It was from this support that stocks bounced following the correction in late January and early February of this year. Related to this point, it is worth noting that stocks at 1815 today are still trading at roughly 80 S&P points above their early February lows at 1737, which of course, represents another line of support for stocks to the downside. Lastly, and perhaps most importantly, the S&P 500 still remains well above the critical 200-day moving average support level, currently at 1761 and rising. If stocks were to breach this long-term support line, the story would begin to change. In the meantime, the uptrend remains solidly intact, despite the recent pullback.

So while we are likely to see some additional downside before this latest correction fully runs its course, a variety of technical support levels remain in place to help stem the move to the downside.

No Meaningful Signs of Stress Outside Of U.S. Stocks

For now, the latest correction in stocks appears to be a garden variety pullback, as all is calm across many of the related stock market stress indicators.

While the U.S. stock market has been suffering over the last several days, credit markets are moving along just fine. For example, investment-grade corporate bonds (NYSEARCA:LQD) continue to advance toward recent highs set last May.

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Although high-yield bonds (NYSEARCA:HYG) were down with the stock market on Friday, they are still just incrementally below fresh all-time highs set early this week.

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And preferred stocks (NYSEARCA:PFF) continue their steady year-to-date rise, despite the ongoing volatility in the common stock market.

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Even emerging debt markets (NYSEARCA:EMB), which were the source of so much consternation earlier in the year, have been rising smartly in recent days in the face of U.S. stock market weakness.

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In fact, emerging market stocks are even showing signs of strength during the recent U.S. stock pullback, as they remain up for the trading week, despite falling along with global markets the last few days.

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Signs of strength are even presenting themselves within the battered U.S. stock market this week. For example, utilities (NYSEARCA:XLU) as an entire sector are higher for the period.

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And more defensive consumer-oriented names, such as McDonald's (NYSE:MCD) have also shown the resolve to move as much as +2% higher for the week.

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In our highly distorted post-crisis markets, typically more sustained and severe corrections have been preceded by signs of stress in credit markets and have seen more highly correlated and universal declines to the downside across anything even related to the stock market. Such has not been the case in recent days.

What To Watch For In The Days Ahead

Despite general signs of order and calm both outside and within the U.S. stock market, the potential still exists that the decline could evolve into something more pronounced and sustainable in the coming days. With this in mind, it is worthwhile to monitor the market segments where the stress is currently most concentrated, to not only watch for signs of acceleration to the downside, but also for any indications that the problem is starting to spread.

For example, much of the downside in recent days has been concentrated in the high-beta segment of the market that had been leading to the upside since the market pullback last May. For example, it was only a few trading days ago on April 3 when the S&P 500 High Beta (NYSEARCA:SPHB) and S&P 500 Low Volatility (NYSEARCA:SPLV) were both up +3.6% year-to-date. But a mere six trading days later, low volatility stocks have opened up a 4.3 percentage point performance advantage over their high-beta counterparts due to the pace of the decline of the latter in the last several trading days. It is worth watching in the coming days how much further high-beta stocks continue to sag and whether they start to drag their low-volatility counterparts down with them.

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Another signal worth monitoring in the coming days is the pale rider of the U.S. stock market in the CBOE Volatility Index (VIX). On Friday, the VIX reached an intraday high of 17.85 in the afternoon, before retreating lower into the close. But this spike in the VIX is consistent with the rhythm of volatility (NYSEARCA:VXX) that we have seen since the beginning of 2013. However, if the VIX breaks out above the 18.20 level, it would likely suggest that something more pronounced is underway. This may include an attack and potential break of critical support at the 200-day moving average, which would be a particularly notable outcome, were it to take place.

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Lastly, keeping a close watch on market behavior as earnings season unfolds will remain worthwhile. Stocks have typically performed well during the peak of quarterly earnings season, including the ongoing farce of companies beating analysts' "expectations". But if the broader market struggles over the next few weeks through the parade of corporate announcements, particularly with so much bad weather from earlier this year already "priced in", it may bode ill for how stocks are likely to trend as we head into May, when so many investors have traditionally sold and gone away until the fall.

Bottom Line

The latest decline in stocks is, once again, notable. While such declines make for good headlines and we are likely to see some further downside before it's all said and done, signs of underlying stress suggesting a more pronounced pullback remain low at this time. This does not mean that the current pullback could not erupt into something more meaningful, which makes how various markets unfold in the coming days worth watching. But more than anything, this latest correction and its accompanying volatility have all of the broader long-term markings of a bull market that is showing signs of beginning to enter its final stages. This will be the real story to watch in the days, weeks, and months ahead. For once the next cyclical bear market phase sustainably takes hold, it may bring with it an experience that many investors are not likely to soon forget.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Source: Assessing The Recent Stock Market Damage

Additional disclosure: I have a meaningful allocation to cash at the present time.