565 points is how far the Dow Jones Industrial Average (NYSEARCA:DIA) plunged at its low point yesterday. It recovered in the afternoon session, narrowing the decline to 248 points. It was a gut-wrenching sell-off that most assuredly stirred fear in the investing public. Yet I seriously doubt that the real reasons for yesterday's carnage, or the losses year-to-date, will receive the attention that it deserves.
The S&P 500 index (NYSEARCA:SPY) cascaded as many as 69 points (3.6%), falling to a new 52-week low, before recovering in the afternoon session and narrowing that loss to less than 1%. It has now declined 9.5% since the beginning of the year, and nearly 13% from its all-time highs.
There are many explanations as to why we are having this fast and furious sell-off in the markets, but I think the real reason is quite simple. It is cause and effect. The stock market began to recover in 2009 because of the fiscal and monetary stimulus that followed the financial crisis. The fiscal stimulus ended in 2010, at which point the Federal Reserve pushed forward with even more monetary stimulus until the end of last year. The stock market responded with a nearly uninterrupted climb until the middle of last year. That was the effect of the monetary stimulus. At the end of the year the Fed reversed course with its first interest-rate increase. Because of this monetary policy tightening, the stock market is now declining, and doing so rapidly. That is another the effect.
I'd like to make it a lot more complicated than that by discussing China, currencies, oil and a whole host of other complex factors, but I think that these are secondary drivers of the decline. Many of these secondary drivers are direct or indirect results of the primary driver, which is monetary policy. The bottom line is that the stock market is now sobering from what has been a seven-year-long bender of quantitative easing and zero-percent interest rates, and the deluge of selling pressure should come as no surprise to those of us who have been steadfast critics of it.
I will paraphrase what I stated last March when the stock market briefly stumbled -
When there is too much liquidity in the financial system and borrowing costs are too low, the result is excessive amounts of leveraged malinvestment. The unwinding is inevitable, and common sense dictates that it begins with the normalization of the Federal Reserve's interest rate policy.
I think the analogy of musical chairs is particularly apropos right now. The Fed's zero-interest-rate policy was a colossal game of musical chairs. So long as the policy was maintained, the music continued to play, which meant that institutional investors could continue to capitalize on extraordinarily low borrowing costs to speculate with leverage on financial asset classes around the globe. When some bowed out to grab a chair, others would step in to replace them. They all knew the music was going to stop. What we have seen in recent weeks is what happens when they all grab for a chair at the same time.
This is not to say that the bull market is completely unjustified. Market fundamentals have improved alongside the monetary stimulus, but not enough so as to warrant the market valuations we saw at year-end. Monetary policy inflated financial market valuations well beyond what they would have otherwise been, based on the improvement in fundamentals. Like a rubber band that has been stretched too far in one direction, market prices are now snapping back in the opposite direction to realign with those fundamentals.
Many are now awakening to the fact that market fundamentals have been deteriorating for some time. We are in the midst of a corporate earnings recession and the rate of economic growth is slowing, both domestically and abroad. The realization of this will likely push prices well below what fundamentals might otherwise dictate, thereby creating opportunities.
Adding to the speed and ferocity of the decline in stock prices is our current market structure, which in my opinion is broken. The traffic cops at the intersection of every buy and sell order are self-serving computer algorithms. These so-called liquidity providers seemingly vanish when there are order imbalances from which they cannot profit. Unlike legitimate market makers, they accentuate price movements by withdrawing liquidity just when the market needs it most.
I am continuing to look for a selling climax that will lead to a short-term bottom in the broad market. Maybe we saw that yesterday, but it didn't feel like it. Markets bottom on very bad news, not good news, and we saw neither yesterday. It felt more like another stage in a gradual bear-market decline, and I still view rallies to overhead resistance levels as an opportunity to sell or hedge. I would welcome that opportunity.
At the same time, I want to be prepared in case the broad market realizes a bear-market decline of 20% or more that presents long-term investment opportunities. For now we are stuck in what could best be described on the tennis court as "no man's land." This is the worst place to be, because we are caught between levels where we could be decisively offensive or defensive from an investment standpoint. As a result, I'm focusing on my shopping list.
What I do on days like yesterday is watch the relative performance of the sectors and individual companies that I have on my shopping list. Yes, even bears have shopping lists. I am looking for relative strength. This is relevant from a trading and investment standpoint. What is outperforming in a significant sell-off, like the one we had yesterday morning, is likely to outperform when the market recovers, as it did yesterday afternoon. This is also applicable when investing longer-term in either companies or sectors, but the relative strength must be considered over a longer period of time as well.
The biggest mistake I think an investor can make in this environment is to buy stocks that are making new 52-week lows. There are many names in the energy sector with stock prices that are very enticing at current levels, based on fundamental valuation or otherwise. A stock making a new 52-week low today is leading the market lower. That stock is also very likely to lag the market when it begins to recover.
The healthcare sector significantly outperformed on a relative basis yesterday. It was the only sector to finish in positive territory. Within healthcare, the biotech sector (NASDAQ:IBB) stood out as a relative and absolute outperformer, having risen 2.7%. Still, even though the biotech sector made a new 52-week low, within it there were names that outperformed the market all day long, and some that spent the majority of the day in the green. Celgene (NASDAQ:CELG) is one of those names, and a name on my shopping list. It exhibited very strong relative strength when the market was near its lows for the session, as well as having finished up more than 4% on the day as the market recovered. It also avoided making a new 52-week low.
Now is the time to cultivate both the buy list and the sell list, as we wait to see what opportunities present themselves.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CELG over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Clients of Fuller Asset Management may hold positions in the securities mentioned in this article. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.