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The stock market is suffering its first meaningful correction in nine months. The initial drop, which occurred between February 27 and March 5, took the broad equity indexes down 5-6%. Markets bounced soon after and are now correcting again and retesting the recent lows around the 1370 level on the S&P 500.

How the market behaves on this retest will be instructive. Investors are attempting to gauge whether this sudden decline is simply an overdue correction of an extended, uninterrupted advance or the start of a more serious move lower. It is possible that this decline marks the beginning of the long-awaited 10% correction in the S&P 500, which in turn could conceivably be a prelude to a cyclical bear market. The weight of the evidence currently argues against the idea that the bull market peaks have been put in, but our investment strategy should certainly take that possibility into account.

Our view of the markets at present is that the recent decline probably does not signal the end of the cyclical bull market, but we are not confident that a low-risk, longer-term buying opportunity is at hand. Markets are likely to remain unsettled for a period of time. Our portfolios are conservatively positioned, so we are inclined to stand pat with our current allocations and see what develops.

Historical Context

This bull market is now 4.4 years old, versus an historical average (past 75 years) of 3.7 years. While further late-stage bull market gains are possible, it is appropriate at this juncture to be focused on defending capital and avoiding potential losses rather than pursuing large gains. In this type of environment, the value of holding cash reserves quickly becomes apparent.

From a technical standpoint, it would be highly unusual for a bull market to end with the advance/decline line (a measure of the breadth of the market advance) having just made a new high. In the past 12 bull market cycles going back 70 years, ten were preceded by negatively diverging breadth several months in advance of ultimate peaks in the major indexes. Not only has this bull market failed to produce the classic, internal divergences that accompany most market tops, the advance/decline lines for all of the capitalization segments of the U.S. market -the S&P 500, Mid Cap 400 and Small Cap 600 - were at new bull market highs just prior to this recent decline. It would be unusual (but not unprecedented) for the market to top out with no advance warning from these breadth indicators. We will have to wait and see if such deterioration develops in the weeks ahead.

While sudden market drops are invariably disturbing, the size of recent declines relative to prior gains must be kept in perspective when assessing the larger question of whether the primary market uptrend remains intact. Even though the S&P 500 is now 6% off its bull-market highs, it is still 10% higher than last summer's lows and 7% higher than levels one year ago. The S&P 500 would have to drop another 5% and break the 1300 level to violate the longer-term bull market uptrend.

A Healthy Dose of Fear
What was more unusual than the sharp recent stock market decline was the length of time that markets had steadily risen without any sort of correction. Volatility has now returned after a period of very unusual calm, and we do not expect markets to revert any time soon to such low levels of volatility (e.g. VIX readings near 10, which are historic lows, for the six months leading up to this correction).

This correction is potentially constructive in that it is washing away some of the excesses and injecting a dose of fear into investors who had become too bullish and complacent about risk assets. A variety of shorter-term sentiment gauges have quickly shifted from complacent to fearful readings, which will likely serve to limit further near-term declines. But it is hard to argue at this stage that risk aversion has returned in any significant way to the financial markets. We have had only a modest, brief correction in stock prices after an extremely long rally, and credit spreads between U.S. Treasuries and junk bonds and emerging-market debt remain near record-tight levels.

It is notable that the market is suddenly fixated on issues such as mortgage-lending problems and the potential unwinding of the yen carry trade. These issues have been hanging over the markets for quite some time, and now they are on the front pages and are shaping market psychology. Psychology can, in turn, influence the fundamentals, and if confidence deteriorates and longer-term risk aversion builds in the weeks and months ahead, that development in and of itself could make an important difference in the performance of risk assets and the economy at large.

Source: Correction Injected a Healthy Dose of Fear Into Extended Bull Market