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A More Challenging But Normal Equity Market

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by: David I. Templeton, CFA

Before I left for a week of vacation at the end of March, the equity markets had begun to exhibit a higher level of volatility. This seems to occur more often than not around this time period each year. This heightened volatility was to the downside and I wrote a post before leaving town noting this was more typical market action. What has been so abnormal about the equity market over the past five years is the fact nearly every calendar quarter since 2013 has generated a positive return. As the below chart shows, prior to 2013, this was certainly not the case.

The markets have had such a strong run since the end of the financial crisis and a near parabolic move since the presidential election, large point moves on the Dow Index equate to more normal like percentage moves. Even Monday's 458-point decline represented a less than 2% decline in the index. When looking back at the 'recent' past, say two years, the +/- 2% price moves seem more the exception than the rule.

When evaluating the index percentage moves on a much longer time frame though, a +/-2% equity move on any given day is actually not that uncommon as seen below.

It is the most recent market environment, say the last five years, that is most unusual and abnormal. Yes, the current year has started on a weak note with the S&P 500 Index down 3.43% as seen in the first chart below. However, at the start of 2016, and through almost two short months that year, the S&P 500 Index was down over 11% as reflected in the second chart below. This 2016 market weakness does not even appear on the quarterly chart at the beginning of the post.

The S&P 500 Index is down almost 11% from its late January high. In spite of this double-digit pullback, sentiment measures appear mixed. The commonly referenced fear and greed index on CNN Money is registering 'extreme fear.'

Conversely, the Equity Put/Call Ratio reading after today's close was .77 and pretty far below the extreme fear level of 1.0. In the February 2016 pullback, the equity put/call ratio twice reached levels in excess of 1.0. For readers, the equity put/call ratio measures the sentiment of the individual investor by dividing put volume by call volume. At the extremes, this particular measure is a contrarian one; hence, P/C ratios above 1.0 signal overly bearish sentiment from the individual investor.

I sound a bit like a broken record in saying company fundamentals appear strong. With earnings growth looking forward one year expected to equal 20%, this should serve as a tailwind for stocks. The tariff issue being pursued in Washington is certainly a headwind. We do think reasonable compromises will be worked out on many tariff proposals though. Some of the recent market weakness is likely anticipating a worst-case outcome.

Much technical damage has been done to the market, like a potential triggering of the Dow Theory being tossed around the last several days. Timing the market is a difficult endeavor, but evaluating one's asset allocation is a beneficial task at this juncture. The economy is not the market, but I do believe both company and economic fundamentals remain positive and support higher equity prices in the year ahead, albeit with higher levels of equity volatility.