Could selling be the new norm for stocks?

Setting the stage for change

Selling has finally returned to the US stock markets, short-circuiting their year-old levitation. This new downside action of the last couple weeks looks very different from anything witnessed in 2013. Is it just another minor and short-lived pullback, the vanguard of a full-blown correction, or the dawn of a new cyclical bear market? The prudent strategy for traders varies greatly with this selloff’s likely magnitude.

Selloffs are a normal, healthy, and necessary stock-market behavior. They are absolutely essential to rebalancing sentiment. The longer and farther markets rally, the more greed and complacency capture traders’ hearts. Their usual cautiousness vanishes, and they race to pour capital into increasingly toppy markets. But this greed soon grows unsustainable and burns itself out once all near-term buyers are in.

The only way to entice in new capital and keep the markets climbing on balance is to bleed off the excess greed. Enter the selloff. When stocks start falling, the great sentiment pendulum starts swinging back from the greed extreme of its arc towards the opposite fear end. Eventually as the selloff matures, stock prices are low enough and fear is high enough to attract new buyers. Then stocks start climbing again.

2013’s extraordinary stock-market levitation didn’t see normal selloffs, which is the main reason it was so troubling for veteran traders. And that is why the last couple of weeks feel so different. Normal healthy bull markets experience 3 or 4 pullbacks per year, selloffs in the benchmark S&P 500 stock index (SPX) that run from 4% to 10%. That actually did happen last year, there were plenty small pullbacks in 2013.

But these minor selloffs don’t bleed off much greed, making much larger correction-magnitude selloffs necessary from time to time. These ultimately run between 10% and 20%, and eradicate a great deal of greed. They happen about once a year in healthy bull markets, and 2013 absolutely should have seen one. The longer stock markets climb without a full-blown correction, the greater the odds one is imminent.

Incredibly, it’s been a whopping 27.5 months since the end of this cyclical bull’s last correction! That is more than double the normal span. This fact alone certainly swings the probabilities wildly in favor of today’s nascent selloff ultimately extending into correction territory beyond 10%. And since it has been so long, the next correction is much more likely to weigh in closer to the 20% upper limit than merely 10%.

Unfortunately 2013’s one-sided levitation lulled speculators and investors into such deep complacency that most have forgotten how brutal real corrections are. This first chart superimposes the SPX levitation since late 2012 on top of the premier stock-market fear gauge, the VIX. The VIX is an essential indicator for gaming corrections, since they only end after fear flares dramatically as measured by big VIX spikes.

From its mid-November 2012 low after Obama’s reelection to its latest nominal record high in mid-January 2014, the flagship SPX blasted 36.6% higher in just 14 months! In 2013 alone, the SPX was up 29.6%. This was more than triple the SPX’s long-term average annual returns around 9.5%. Such big gains stuffed into such a short period of time should have triggered a correction, but one didn’t happen.

The reason is the fabled Fed Put. Stock traders believed the US Federal Reserve would greatly ramp up its money-printing debt-monetizing QE3 campaign in the event of any material stock-market selloff. With the perception that the Fed had traders’ backs, there was no need to worry about normal stock-market indications of overboughtness and hence imminent selloffs. Traders just immediately bought every dip.

The result of all this central-bank meddling in normal stock-market cycles is the one-sided levitation in this chart. While there were plenty of selloffs, none evolved beyond the small-pullback stage. And half of them didn’t even reach the 4% pullback threshold! Briefly going through them offers some essential context for understanding today’s nascent selloff. The first in this levitation came in December 2012.

That was when late 2012’s so-called fiscal cliff approached, and it looked like the US Congress was at an insurmountable impasse. Still, the SPX only drifted 3.1% lower over 7 trading days. The Fed had launched QE3 a few months earlier in September 2012, and more than doubled it that very month of December 2012. Stock traders figured there was no need to sell since the Fed could expand QE3 again.

In late February 2013, another selloff began cascading on European fears. The Italians almost voted in a political party ready to default on Italy’s gargantuan national debt. And Italy is the world’s third-largest debtor nation, so the shockwaves that would unleash on fragile European banks would be catastrophic. But with the Fed Put in place, American stock traders capped that selloff at a mere 2.8% in 4 trading days.

In mid-April the SPX again dropped 3.2% in 5 trading days, this time stock traders were spooked by the precipitous panic-like plummet in gold. But gold soon bounced as the futures forced liquidations ran their course, and the SPX followed. Within a couple of weeks, the SPX would be back up to new record highs. Again with the Fed’s massive QE3 inflation effectively backstopping stocks, why bother selling?

The levitation’s first real pullback arrived in mid-May and cascaded into late June. The lion’s share of that came after Ben Bernanke gave a post-FOMC-meeting press conference where he laid out the best-case timeline for starting tapering the QE3 debt monetizations. This helped hammer the SPX down 5.8% in 23 trading days, but it was still far from a correction. It was too shallow to break the euphoria, so rallying soon resumed.

The next pullback arrived in August on reports of weak retail sales. The US stock markets were getting very expensive by all valuation metrics, and without earnings growth those stock prices simply wouldn’t be sustainable. This pullback weighed in at 4.6% over 17 trading days. But again with the Fed on the case, American stock traders were soon buying again. They actually started to embrace the QE3 taper.

It was universally expected to start at the FOMC’s September meeting, as Fed officials had been working overtime to set that expectation. So when the Fed surprised and decided not to start slowing its bond buying, stock traders figured the Fed must think the US economy was still too weak to weather the shock of QE3 tapering. So the SPX pulled back again, but barely at 4.1% over 14 trading days. And that was it.

After that theatrical partial government shutdown ended in mid-October, the US stock markets were off to the races for the rest of the year. The average of the 5 material selloffs the SPX experienced in 2013 was just 4.1%, barely pullback-magnitude. The lack of natural sentiment-rebalancing selloffs worked to breed extreme hubris. Traders came to believe stocks were so awesome that they would never correct!

With stocks powering higher so dramatically last year, stock-price gains far outpaced earnings growth. This drove stock valuations to lofty bull-slaying extremes by late last year. More and more traders started to realize stock prices weren’t sustainable unless earnings soared to justify some of 2013’s massive gains. So the critical Q4 holiday earnings season became very important for stock traders’ sentiment.

And as January 2014 rolled through, these Q4 results were generally weak. Though profits were beating lowered-expectations bars, they were often lower than a year earlier. And sales were definitely down, an ominous omen. Cost cutting, firing people, can only boost earnings for so long. If businesses can’t grow sales, they can’t grow earnings over the long term and can’t support and justify lofty stock prices.

Though the SPX had stalled in January, the recent bout of selling didn’t start until near the end of last month. Chinese factories were reporting contraction, they were shutting the doors and sending workers home because there was insufficient demand. And with China’s factories making stuff for Americans and Europeans to buy, this implied weakening consumer demand and consumer health here in the US.

And then emerging-market fears started to mount too. Argentina had to abandon defending its faltering currency, while Turkey’s central bank hiked its overnight lending rate by 425 basis points to 12.0% to attempt to stave off a mass exodus out of its own currency. All this happening together was finally enough to shock greedy stock traders from their complacent slumber. They finally started selling again.

The result so far is a nascent 5.8% selloff over 12 trading days ending this past Monday. Though its latest low makes this pullback the same size as the June one on that QE3-tapering scare, this one happened in half the time! Thus it is much more severe and very different from anything witnessed last year. Yet despite its considerable size by 2013’s low standards, this selloff remains small in the grand scheme.

The SPX last topped at 1848 on January 15th. So to merely get to the 10% correction threshold, the SPX would have to fall to 1664. That’s a long ways down from here! It would drag this index back down near its early-October lows, as the 10% line in the chart above shows. Considered another way, the SPX first hit 1664 in mid-May. So just a garden-variety 10% correction would effectively erase all gains since May!

But that mid-January high was 27.5 months after the SPX’s last correction, far beyond the once-a-year average. So again the odds favor the next correction being considerably larger than 10%. A 15% retreat in the SPX would drop it to 1571, a level first seen in early April and then again near the bottom of the large QE3-tapering-timeline June pullback. 15% would erase about 2/3rds of the SPX levitation’s advance.

And finally check out that lower 20% line, a full-blown correction. To fully rebalance sentiment and give this bull any chance of powering higher again, the SPX would have to fall 20% from its recent high to 1479. It first hit these levels in mid-January last year, so a large correction would nuke virtually all of 2013’s outsized gains! That is hard to imagine, and I bet most stock traders haven’t even considered it.

Next page: Understanding corrections

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