In the California Gubernatorial debate last night, Arnold Schwarzenegger told another candidate attacking him to "have a little decaf" (you have to imagine the accent). That caught my attention because after a sound market drop yesterday, we could use a little decaf. The funny thing about a correction is that it is easy to expect when prices are going up - it isn't so easy to take as it develops and fears mount that it is the beginning of a more significant decline.
Our first reaction to a high volume decline from an intermediate-term overbought condition is to question our Upside Ahead? thesis that while stocks are overbought and extended from their lows using monthly data, the momentum in the equity market is historically rare and should ultimately continue. It is natural for us to immediately let one day question an intermediate-term thesis because it is typical human nature.
We handled this gut check by taking a step back, contemplating the stated reasons for the decline, while looking for any fundamental or technical change that would demand a reversal of our intermediate-term position. We have learned from our own experience that an immediate emotion based response to any kind of market has typically been the improper response.
The widely held reasons for the recent decline in the equity market seem three fold:
• Weak Dollar. This week we noted (Don't Cry "Uncle" Just Yet) how broad based weakness in the U.S. Currency after a 15% decline has historically been a better intermediate-term positive sign than poor indication for equities. The immediate response we received was that we were only using the data in the context of a secular bull market. While that is true, there were periods of pronounced weakness in that secular bull market and none took place after a 15% drop in the US Dollar Index.
• Higher Oil Prices. Yesterday's negative market action was attributed in part to a 4% increase in the price of oil. The jump was caused by an unexpected production cut announcement by OPEC. While it is true that prices jumped 4%, they are still down significantly from the end of August. The market chose to focus on the 4% increase yesterday rather than the 12.5% decline in the prior month - even including the jump (Exhibit 1). This suggests the spike in oil was an excuse for profit taking.
Exhibit 1 - The Spike In Oil Isn't Overly Dramatic
• Corporate "Confession Season." Recently there have been a few negative earnings pre-announcements, which have again kicked up speculation that earnings may disappoint - especially given the recently raised expectations. Clearly, poor fundamental results and EPS disappointment and reductions were a major reason for September-October declines over the last couple of years. Again, the human mind defers to the most recent event, which is the negative pre-announcement by Verizon (VZ). In our view, we should look at overall market trend vs. individual company performance (Exhibit 2). Practically all our fundamental Independent Market Research (IMR) suggests improvement, not deterioration in the bulk of the S&P 500 (SPX) sectors.
Exhibit 2 - A look at EPS
Source; Baseline Inc.
Maintaining Favorable Position. The risk here is to make an intermediate-term shift in our position based upon near-term action. Throughout the advance, we have held that the equity markets are in a rare momentum driven mode off an important and identifiable turning point. We have also understood that it remains a liquidity driven momentum market, and there could be shakeouts of anywhere between 4-7%. We are in one such period. The problem is that you only know well after the fact, whether it was a correction or something more significant.
It Is What It Is. Now that we have the problem of identifying what it is, we look for a solution to help determine if the current move is a simple (but nasty) pull back or something more significant. One thing we look to is whether there is any intermediate-term trend damage in the market action. It is important here to look past simple price and not let near-term fluctuations dictate investment decisions in an intermediate-term liquidity driven momentum market.
In our view, it is dangerous in a liquidity driven emotional market to go strictly by price because there have been instances where price "breaks" were not followed by weakness and actually proved to be low points (Exhibit 3). At the end of the day, unless there is significant intermediate-term trend or indicator deterioration or a fundamental turn in the FTN Midwest Research IMR work or a significant change in the liquidity picture - then we expect investors to use meaningful drops (4-7%) as an opportunity to add to positions.
Thus far, the uptrend (higher lows and highs) remains in tact and the SPX is rapidly approaching oversold levels that have generated bounces in the context of the current rally that began in March (Exhibit 4). For now, the discussion shouldn't be if higher prices resulting from liquidity and momentum are right or wrong - because it just is what it is until more identifiable intermediate-term trend changing evidence presents itself. We can't say if the correction has fully run its course, but we do believe it is getting there.
Exhibit 3 - Pure Price Hasn't Been The Best
Exhibit 4 - Uptrend and Getting Oversold
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