Start of ‘The’ Correction, or (Another) Buying Opportunity in Stocks? – Published in Noozhawk on Monday, August 4, 2014

This past week’s stock market performance shocked many investors who have grown accustomed to steady gains for stocks — week in, week out.

The combined drop of nearly 400 points for the Dow Jones Industrial Average over the past two trading sessions (July 31-Aug. 1) led the stock market to its worst weekly performance since January.

This result prompted some investors to ask: Is this the start of a major correction, or just another in the long line of buying opportunities?

Investors have certainly been rewarded over the past two years plus when they have assumed the risk of stepping into stocks each time we have seen more than a 1 percent correction in the overall stock market. Stocks have not suffered a 10 percent or greater correction for well more than two years. This trend has fostered an extreme, and some would say dangerous, level of complacency with investors.

As we have traveled deeper into the bull market, the “big money” institutional investors running mutual funds, hedge funds, pension plans, private equity funds and the like, have been pulling money out of stocks, while the smaller investor has continued to buy.

The most recent survey of advisors shows a bullish percentage of 56 percent. Typically, a high reading on this survey is an indication that a correction is more likely, if other factors are also present, such as divergences among the market leadership (we are definitely seeing this today), and the ratio of new highs to new lows goes down, even as stock continue to make new highs.

Small Caps in a RUT

The Russell 2000 (symbol RUT) is down significantly from where it began 2014, closing Friday at 1,115, down 50 points year-to-date, or 4.2 percent. More than $6 billion flowed out of high-yield (junk) bonds in July alone. These two segments of the market tend to be more sensitive to market directional changes, and are leading indicators (they more first) when there is a major change in market direction.

Certainly there were drivers that could help explain why last week’s market performance was poor: Argentina officially defaulted on some of its bonds after negotiations with some hold-out hedge funds collapsed, prompting Standard & Poor’sto downgrade these bonds to default status; tensions rose significantly in the Russia/Ukraine situation after new sanctions were announced; tensions between Israel and Palestine spiked; the Fed meeting failed to give us any clear direction on the timing of interest rate increases; and the employment data were a bit disappointing (although bad news is good news — sort of — when it comes to weaker employment data because it gives the Fed more flexibility with regard to the timing of future rate increases).

But none of this can really effectively explain why stocks got hit so hard Thursday and Friday. What can explain this market action is the fact that stocks are grossly overvalued by any measure. When stocks are overvalued, as I have written in severalprevious columns, anything, even something relatively insignificant, can trigger a market sell-off.

That is exactly what we are seeing with the current market environment — stocks are very expensive, so the least little thing can spark selling as nervous investors run for the exits to try and lock in the gains they have made, and avoid losing those gains.

Another key fact about the current stock market level (bubble) is that we have a significant percentage of investors holding stocks right now who are not really stock investors. Those investors who would normally buy bonds, real estate and other investments are holding stocks because stocks are the only game in town.

These investors simply cannot generate the returns they need/expect from other asset classes (like bonds), due to factors such as historically low interest rates, the difficulty in getting loans (for real estate), etc. As a result, these investors are reluctant stock investors who really are not suitable to own stocks, and they will be the first to jump ship if there is a slightest sign of a major correction.

As we enter August, and a new month of trading for stocks, it will be interesting to see if investors once again see the recent slide in stocks as a buying opportunity. We have seen 27 new highs set by the S&P 500 so far in 2014. Will we see number 28?

It is possible, but each time the market pushes up to new highs, valuations get stretched even further, placing the market in an even higher degree of peril. The healthiest thing for the market right now would be for it to have a 10 percent to 15 percent correction. Were this to occur, most would feel that valuations were once again attractive enough to invest, and we could see a further advance, possibly to new, all-time highs.

If we do not see a correction in the very near-term, my feeling is that in the September to October time frame, stocks will experience a much larger correction or crash, with at least a 20 percent drop. In fact, 20 percent could look like the market getting off lightly, given some of the historical drops we have seen during the September/October time-period historically.

This week’s action will be telling — if we can stabilize early this week, stocks have a good chance of a rally back to or near all-time highs. If stocks continue to slide, I would expect panic to set in, and to see a sizable drop for stocks.

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