The Catalysts For A Correction

by: Financial Sense

By Tom Smith

As I write, the S&P 500 continues its march higher. This has to be one of the most hated bull markets on record. Really all strong markets are met with pessimism for the majority of their run higher. When your neighbor tells you of their latest success in day trading, that is when you need to be concerned.

As the market has moved higher there has been an endless parade of characters on TV and in print saying how much more constructive they would be on the market if it went down 10%. Typically we don't see aggressive moves lower when we are on the lookout for them.

There has not been a major 15% move lower for over 600 days now. So, some are saying that based on that we "should" see a pullback in the spring or summer or during earnings season or during the fall elections (take your pick).

How does the current length of time without a 15% pullback compare with other past strong markets? I ask this because there is a long list of people calling for a correction because "we need one" or it would be "healthy". I feel that commentary like this without context is not really worth all that much. In 6 of the last 8 decades there has been a period of 950 days or more without a 15% correction. In the 1930s the longest run was 515 days and the 1970s was just a decade of pain. So, in six of the last eight decades we have had runs without a 15% pullback that have on average been far longer than the current streak. We will exclude the 1970s from this next calculation because there were no periods of more than 500 days without a correction. If you take the average of the longest period without a major correction from each decade since the 1930s the average period is 1287 days!

There is some interesting work in behavioral finance currently being done. There is one area that focuses on headlines. Headlines are a great contrary indicator. When they are euphoric the market tends to correct. When headlines become overly bearish the market tends to do well. The financial press has responded to the latest string of new highs by calls for a top and continuously calling for a correction. This is bullish for the market.

There have been some consistent catalysts for pullbacks in the past. The two most consistent drivers of weak markets have been inflation and policy. Spikes in energy prices and Fed tightening have been the culprits behind just about every major pullback we have experienced since the 1970s. In 1998 there were a string of global financial crises with currencies and the collapse of LTCM driving the market lower.

So, let's look at the chances for those two issues to derail things this time. If you chart the price of oil with the market you will consistently see a huge spike in year-over-year energy prices right before the pullback. That issue is not a concern at the moment. Oil prices are slightly down year-over-year.

The Fed has actually been injecting less money into the system since late last year. Ben Bernanke announced the beginning of the taper last year. The taper will likely come to an end around October. This news is out. It is rarely the devil you know that causes problems. Fed policy hasn't changed in some time.

In the past I have focused you on another key area to monitor the overall direction of the market. The Leading Economic Indicators (LEIs) give us valuable insight into the economy and the market. Remember: the market is a leading indicator. The market itself gives us clues as to what the future holds for us. The LEIs took a breather early this year in the face if a frigid winter. The market did have a sharp correction in response to the slowdown. As the LEIs have improved since the spring, the market has continued its move higher. Frankly, I see nothing alarming in the long-term trend of the LEIs right now.

conference board lei
Source: dshort.com, annotations added

Consumer sentiment is also not in the euphoria stage. When everyone is certain the market will go up forever we all need to look out.

What is a catalyst for a major correction? A spike in energy prices and sharply higher interest rates have been two of the leading causes for pullbacks in the past, and that is where I am focusing my attention. Also, we need to pay close attention to quarterly earnings, whic are currently coming in on the strong side. Announced numbers and forward guidance, as always, need to be strong. If things begin to deteriorate in any of these areas then it will be time to be more cautious.

When we are in a bear market things don't just get better because we "need" a move higher. The market moves higher ahead of improving fundamentals with a supportive central bank. When the market is in bull territory it doesn't end because we "need" a break. When economic conditions deteriorate, when energy prices spike, and rates move sharply higher the market reacts to that also.

Those are the potential pitfalls out there for the market. Right now there continues to be more right than wrong with the market. There are areas of the market that are not performing well certainly. There are many stocks, as is often the case, that are in their own private bear markets. But, the weight of the evidence remains in the bull camp for now.