What Now?

by: Eric Parnell, CFA


Summary
 
- Exploring "what now" after a heck of a week.

- Perspective on technicals and fundamentals.

- What's next and thoughts on what to do when next finally comes?
     
    
It was a heck of a week. The S&P 500 Index dropped this week by more than -7%, which marked its worst weekly performance in more than seven years. Following this drop, the benchmark index closed the week at more than -9% below its ultra long-term 400-day moving average. Put simply, it looks and feels ugly out there right now. So what should stock investors reasonably expect going forward from here?
 
I’m no bull. Before going any further, it's important to emphasize that I remain long-term bearish on the U.S. stock market. I believe stock market consequences will ultimately have to be paid for years of recklessly aggressive monetary policy and massive sovereign and corporate debt accumulation that inflated asset prices well beyond sustainable levels. But just because I'm bearish on the stock market over the intermediate term to long term does not mean that I think all of this payback will happen overnight. That’s simply not the way that the stock market cleansing process works (even the onset of the Great Depression and Financial Crisis unfolded in various fits and starts over a reasonable period of time).
 
On technicals. The S&P 500 Index is now -17.83% lower through Friday from its all-time high exactly three months ago on Sept. 21, 2018. This is a lot of downside over a very short period of time, which of course is the type of elevator going down declines that can take place when a stock market is trading at historically peak valuations. In the process, the S&P 500 Index has set a lower low after reaching a new all-time high and in the process has fallen back to levels last seen nearly a year and a half ago in July 2017.
 
But with all of this being said, the following also must be considered.
 
First, its trading more than -9% below its 400-day moving average effectively matches the maximum downside gap reached during previous corrections on Oct.3, 2011, and Feb.11, 2016. For what it’s worth, it also matches the initial downside breaks below the 400-day moving average before hitting a short-term bottom both on Dec. 20, 2000 and Jan. 22, 2008. In short, the stock market historically only goes down so far on its initial downside move, and we are currently at this threshold.
 
Also, the Relative Strength Index on the S&P 500 Index now stands at 22, which marks one of the lowest readings in the post crisis period. Given that any reading below 30 is considered oversold, the S&P is overdue for even a short-term rebound at this point.
 
Furthermore, it should be highlighted that the 200-day moving average (the red line in the chart above) is still trading well above the 400-day moving average (the pink line in the chart above) even in the aftermath of this current market decline. It's also important to note that the 400-day moving average is still solidly upward sloping. These points suggest that we are at the very early stages of any sustained downside move at this juncture and that bounces are likely to occur in the short term even if they end up being to lower highs than before.
 
So while considerable damage has been done to the S&P 500 charts during this ongoing correction, the magnitude of the damage sustained thus far is reaching various readings and historical extremes that suggest some sort of short-term mean reversion is likely and overdue at this stage.
 
A final editorial point before wrapping up the technicals. If the S&P 500 Index ends up falling another 2.17 percentage points in the coming days and weeks and ends down -20% or more from its all-time highs before rallying, this may meet the often cited quantitative measure of a bear market, but it would not be what I would consider a true bear market. Instead, it would be nothing more than a scratch or a flesh wound at this point. Why? Because bear markets aren’t shorter than the shelf life of most fresh dairy products at the grocery store. Bear markets are long lasting over the course of at least a year, if not a couple more, and put investors through some repeated pain and reflection before they are all said and done. It may end up being the start of a bear market, but it wouldn’t be a bear market in and of itself.
 
 
On fundamentals. While the U.S. stock market has been issuing a foreboding signal about what may lie ahead for the domestic and global economy, to date the underlying economic and market data remains sufficiently strong that a meaningful short-term bounce in the S&P 500 Index cannot be ruled out. For while we have certainly seen some renewed weakness in the housing market data in recent months, it's also worth noting that other key drivers such as real personal consumption expenditures and real corporate earnings growth remain solidly positive.
 
Moreover, the unemployment rate remains at cycle lows with no initial signs yet of turning higher.
 
Dissecting earnings growth one step further, it's particularly notable that GAAP earnings forecasts that are still projecting double-digit positive growth for the coming quarters have experienced only relatively minor downward revisions since late September over the course of the current stock market correction. The same can be said of a number of key economic forecasts. If underlying economic and market conditions are on the brink of falling apart, it's not necessarily showing up in downwardly revised growth and a number of key earnings forecasts. Such prognostications have a history of being notoriously wrong, so perhaps this will ultimately change. But in the meantime, as long as this data holds up, it remains supportive of a short-term bounce.
 
What’s next? Let’s say the stock market finds a bottom and starts to bounce in the near term.
 
The next and perhaps more important question is what to do with this bounce.
 
First, the bottom line. If you are overweight or even neutral weight to stocks in your portfolio strategy, any short-term bounce should be viewed with an eye toward profit taking and dialing back allocations on the margins (in other words, don’t sell everything at once. Instead, consider selling off the least conviction names and continue to hold the rest). This way, even if stocks blast back through the 400-day moving average in early 2016 style, you will still be allocated to participate but you will have dialed back risk exposures in the event that the broader market fails and turns back lower instead.

Next, the levels. Right now, if the S&P 500 Index finally bottoms and starts to rally in the near term, the key level to watch is its 400-day moving average currently at 2661 and rising at a decelerating rate. This alone would be a healthy 10% bounce from current levels. Historically, a common development once such a bounce takes place is that stocks will rally back to the 400-day moving average, only to subsequently fail and fall back further to the downside. To illustrate this point, a comparable chart from 2008 is shown below. Notice how the S&P 500 Index rallies from its March lows that are well below its 400-day moving average through mid-May where it reaches as far as the pink line before falling back to new lows.
 
 
An important additional level also must be considered. At this stage of the correction, the 50-day moving average (blue line in the earlier chart) is dropping like a stone and appears poised to cross below the 400-day moving average. If this takes place by the time that stocks finally bottom and start to bounce, expect stocks to struggle at this key medium-term technical level.
Lastly, the action. If you are seeking exit strategies from selected equity allocations in your portfolio, it's upon arrival at these key technical levels for the broader market – the 400-day, the 50-day, and also include the 200-day moving average – that an investor should be looking to pull the trigger on any reductions in stock allocations.
 
 
The bottom line. It was a bad week for stocks and the latest in a long line of bad weeks stretching back over the past three months. While the long-term outlook for stocks may be murky, short-term technicals and fundamentals suggest that a measurable rebound back to the upside could still take place in the short term. It remains important to stick to your investment philosophy and program despite this recent volatility, but if you are inclined to strategically lower your allocation to stocks in the wake of this recent correction episode, look to use key technical levels such as those detailed above to help determine exactly when it's time to send selected stock names to the exits.

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