In the last edition, I spoke to the overall conditions that were affecting the stock market. In this edition, I will address the trading environment of the domestic stock market, the early signals that indicated the market was headed towards weakness, and expectations of where the market is likely to head.
For estimating the fair value of a stock, the most fundamental approach uses expected earnings growth and interest rates to arrive at a price to earnings ratio or PE. In periods of high expected growth and low interest rates, the stock market typically rises, as it did during the last half-decade. PE ratios are usually high relative to their historical averages. Conversely, low expected growth or higher interest rates would likely cause lower valuations, lower PE ratios, and thus take the market downward. Changes in the direction of expected growth and interest rates therefore materially impact the direction of the stock market.
As discussed in the previous edition, U.S. economic data and other considerations have moved the Fed away from its six-year, easy-money remedies. About a year ago, the Fed halted its quantitative easing program (QE) and it recently upped short-term interest rates. For credibility reasons, the Fed would not have begun its policy reversal unless it expected to follow through with tighter monetary policy and higher interest rates. Investors should also expect this change.
Usually when the Fed raises rates after a period of recovery, it signals an “all clear” – the economy has recovered, and it’s time to buy stocks – smooth sailing ahead. The downward pressure on stock prices from rising rates is offset by the upward pressure caused from the positive economic outlook. But this time seems different. Many believe that the Fed’s actions have actually spooked the global financial markets, adding to the market’s confusion and its recent volatility.
Globally, the economy has not seen the same levels of recovery as what the U.S. has seen. The economies of China, Japan, and Europe – all are experiencing structural economic weakness. The economies of the “old-guard” oil producers – the Middle East, Russia, and Venezuela – have been rocked by the more than the 60% decline in oil prices over the last year. The economies of the emerged and emerging countries of Asia, Africa and South America have seen drops from the slowdowns in globalization and world trade. As further confirmation of the global state of affairs, the IMF again revised world economic growth rates downward in October 2015. Many are calling the Fed’s actions of raising rates premature.
Regardless of the other headwinds facing the market, such as the recent geopolitical flare-ups, these two influences – the Fed’s change in monetary policy and the world’s dismal economic growth outlook – are the primary causes of the U.S. stock market’s slide over the last month. Look closely at the S&P 500 chart below and the events indicated by the arrows.
The chart depicts the price action of the S&P 500 index for 2014 and 2015. Also with price, is its 50-day moving average and its 200-day moving average. The first event to note is the Fed’s halt of QE in November 2014. After working through the initial volatility following the Fed decision, the index started higher but could only muster whipsaw trading for another eight months.
This extended whipsaw action, without a further move up, was the first signal that the market was weakening. Indecision characterized the market. Also indicated by the long period of range-bound trading, was a large transfer of share ownership. Sophisticated investors have been selling to the less-sophisticated, smaller, and weaker investors. This happens every time at a market top. The more savvy market participants recognize the impending weakness and cautiously start to reduce risk, methodically selling their positions. Meanwhile, the smaller investors continue to make their monthly 401(k) contributions, unaware of the weakening market that they are buying into.
Finally in 2015, the market cracked, first in June and then again in August with a sizable loss of 10%. Both moves down were attributed to the declining Chinese economy and the broader global slowdown. Technical confirmation of a likely further correction came when the 50-day moving average crossed downward through the 200-day moving average. This is commonly referred to as a “death cross” and is a signal of significant damage to buying sentiment. Also, because the price has dropped far below the longer-term moving averages, a significant portion of the market ownership is now in a losing position on recent purchases. When this condition happens, fear starts to rise, potential buyers don’t buy and owners of shares are more apt to fold. Selling pressure now dominates and prices fall.
Now for the question that naturally follows: “How much more will the market drop?” For a multitude of reasons, the stock market will likely continue its path further down until the first significant level of buying support is reached. This level is when the S&P 500 index reaches the price territory of 1,600. (For now, take my word for it. We’ll discuss the reasons in further editions.)
Beware – within the bigger trend down, the market is likely to have counter moves back up. Sometimes these bounces can be as much as 5% or more. The market typically does not go straight down. Previous price levels of buying support stabilize the downward trend and short-term selling pressure subsides. Some investors try to “catch a falling knife,” buying into a declining market in a mistaken attempt to time the bottom. Some “short” investors (profit when prices fall) start to close their positions and take their gains. And some other investors are forced to buy for a variety of reasons. While providing a pause in the bad news, all of these buying forces are transitory to the greater downward trend and wrongly provide investors with false hope. A bounce could very easily occur soon, when the S&P 500 hits the 1,800 level – now within range of its current price.
The market decline was bound to happen after the Fed halted QE and signaled its intent to raise interest rates. Add to this the global economic slowdown, and the recipe for a bear market is complete. Technical indicators and the market’s price action have confirmed the market weakness. The yellow flag has been flying for some time and now has turned to red.
If you are thinking about buying stock, the most prudent course is to wait until the S&P 500 index reaches the 1,600 range and then evaluate the market forces in play at that point. Alternatively, you could wait until the S&P climbs above its previous high of 2,100 or, at least, wait until it is consistently stays above its 200-day moving average. For those more daring who may trade the downturn, go “short” only after a greater than 3% bounce, have pre-defined and steadfast stop-losses, and don’t be afraid to take your gains after a 5% drop in the market.
Christopher Petitt is the author of the book, The Crucible of Global War: And the Sequence that is Leading Back to It. It is available for sale at Amazon.com, Barnesandnoble.com and for order at bookstores everywhere.