October 16, 2014
Dissecting the Decline
Comparing this Decline to the Previous Five
- Breadth and valuations argue for further market losses.
- Sentiment & Macro factors argue for losses to be limited to the 2014 lows.
The S&P 500 is down 7.3% (on a closing basis) from its September 18th high. This is the sixth correction of at least 5% since the 19.4% drop that ended October 3, 2011. The question we have been getting from clients – is this another one in a series of quick pullbacks within an ongoing uptrend, or is this the early stages of a major decline?
Below is a table with a simple summary of the aforementioned declines since October 2011.
Looking beyond the above simple summary (but sparing you the additional tables), current multi-cap breadth (“multi-cap” referring to small-caps, mid-caps, and large-caps) is weaker than the median of the previous five cases. We have written in the past how the strength of an overall index is typically supported by the prices of fewer and fewer companies, until the index starts to rollover to match a greater number of declining stocks. One of the ways we like to examine the internal strength of the market is a) to compare the percent of stocks above its 50-day moving average (now only 12.8% versus the median of 23.3%), and b) to compare the percent of stocks above its 200-day moving average (now only 30.2% versus a median of 45.8%). (Note: Those current percentages were based on the close of October 14th).
The breadth is more similar to the 2011 and 2012 declines, which witnessed the larger of the previous declines.
Each of the five previous corrections ended with extreme pessimism. The VIX Index of implied option volatility spiked during each of the corrections but since mid-2012 has remained at historically low levels. Wednesday’s close of above 26 is higher than the median at the end of the five previous corrections (21.4). But it’s worth noting that the VIX spiked to 34.5 by November 2011, so it is possible that there is much more crowd fear to be had, taking a typical ten percent decline to a drop closer to the February 2014 lows. But this is just one sentiment measure. Taken together, sentiment indicators are currently similar to previous declines, suggesting a crash in the stock market is unlikely.
There are so many ways to value stock. Even a concept as simple as a price-to-earnings (P/E ratio) can be nebulous because of the varying way to measure earnings (past-, forward-, relative-, absolute-, ex-items-, operating-, as-reported-, etc.). So instead of running through a tutorial, let’s just agree that valuations are higher today than they were during the previous five corrections. Maybe the correction ends today, but the valuations make it reasonable to expect a drop of a few more percentage points.
By most metrics, economic growth is slightly better now than it had been during the previous five recessions.
In measuring breadth, sentiment, and valuations we looked at then vs. now scenarios. The end result of those comparisons is that we expect this decline to be limited to the February 2014 lows (though it could be over with just another day or two of capitulation selling). But in reviewing the macroeconomic environment, we’ll look forward a bit. The difference between a 5-15% selloff and a 35-33% selloff is whether or not we are heading into a recession. We have our concerns for late 2015 as the US adjusts to an interest rate hike likely mid-year, but the economy is strong enough now to expect a stock market decline to be limited to the February 2014 lows, with a reasonable expectation of a limit at the April 2014 lows.
Consumer sentiment has responded to consistent job growth and improving unemployment benefit claims. GDP is tracking at 3% growth for 2014. Data releases concerning jobs, home sales and business investment have beaten expectations. Consumer confidence seems to be improving; credit levels are improving as consumers are more willing to spend.
Oil prices are way down, allowing for more money in consumers’ pockets if energy prices remain depressed. The increase in spending, especially with the holiday season around the corner, could boost growth in retail and leisure as transportation costs for firms decrease as well. The recent performance of the leading indicators suggests that in two to three quarters the U.S. economy will have moved mostly out of recovery and into expansion.
The bottom line: Some conditions are worse than they were in recent 5% declines, especially valuations and market breadth. More short-term losses can reasonably be expected, perhaps another seven percent, bringing the market down to its February 2014 low; a total drop of about fourteen percent. But most likely just two-to-five more percentage points of decline will occur, down to the April 2014 low. Looking beyond the short-term, our intermediate-term indicators (mostly fundamentally based) have not broken down (but we have concerns for later 2015). As long as a recession appears unlikely, a correction should be viewed as an opportunity for long-term investors, like you, to add to market positions.