Corrections are major nontrivial events that slaughter the unwary. They slash stock prices dramatically enough to bleed away all greed and rekindle widespread fear. Today’s stock traders, coddled by the Fed Put last year, are not prepared to weather a correction-magnitude selloff. It would no doubt break them psychologically, which means any major selloff might have a big problem conveniently stopping by 20%.
All year long hardcore contrarians like me warned that the stock markets’ giant gains were certainly not fundamentally justified. They were just the result of the Fed manipulating trader psychology through its gigantic debt monetizations. So as the Fed continues to taper QE3 in 2014, and stock markets continue to sell off, it is really going to rattle euphoric stock traders. Their selling will feed on itself and intensify.
So while a large high-teens correction is the absolute minimum SPX selloff we need to see, there is a very good chance it will edge through 20%. Anything above 20% is bear territory. And once a new cyclical stock bear is underway, stock prices are usually cut in half before a new cyclical bull is born. This final chart zooms out to today’s entire cyclical stock bull. And it is wildly overextended by any standard.
In the 4.9 years between March 2009 and January 2014, the flagship S&P 500 powered an extraordinary 173.2% higher! This is far beyond the average size and duration of mid-secular-bear cyclical bulls of a doubling in 34.8 months. Our current epic specimen was at 58.3 months in mid-January, way too old. Provocatively the last cyclical bull that topped in October 2007 hit 60.0 months when it gave up its ghost.
Cyclical stock bulls rarely last much longer than 5 years, and we are right there. Today’s bull was actually totally normal before 2013’s crazy distortions from the Fed Put. It climbed in a normal horizontal parabolic trajectory (see yellow line above), with sharp initial gains tapering off as it matured. It experienced a 16.0% correction starting 13.5 months into the bull, and a major 19.4% one 9.9 months after the first ended.
Everything made sense, the stock markets were very tradable, and they weren’t euphoric. But the reckless Fed ignited a decoupling from this healthy normalcy in early 2013. Right when the overextended SPX should have been correcting, it broke out above its normal rallying curve. Provocatively a 20% correction would merely take this index back to that normal curve, which still isn’t low by any stretch of the imagination.
Though the ridiculously-too-long 27.5-month span since the end of the last correction is very clear above, some stock bulls love to point out a near-correction in mid-2012. Indeed the SPX fell 9.9%, which certainly rounds to 10%, over 42 trading days. But even crediting that as a correction really doesn’t help the bulls at all. Since its end, it has still been 19.5 months since the last correction, which is still far too long.
Remember the whole purpose of corrections is to rebalance sentiment, to bring prevailing fear. That is evident through the VIX implied-volatility index on stock-index options traders’ collective bets. The higher this gets, the more scared traders are. Full-blown corrections don’t end before the VIX spikes well over 40! The serious fear ignited by this bull’s two previous corrections are sure evident in their VIX spikes.
The past couple weeks’ selloff, despite its sharpness, has merely pushed the VIX back up near 21. This isn’t much higher than it was during 2013’s minor pullbacks, which suggests sentiment rebalancing and hence selling has a long ways to go yet. Stock traders are taking big and unnecessary risks if they buy stocks before we see an outsized VIX spike. Before that, any short-covering relief rallies should soon peter out.
With this cyclical bull massive beyond belief, and the stock markets still technically mired in the sideways-grinding secular bear that was born in early 2000, and stock valuations up near toppy bull-slaying extremes, smart speculators and investors should be very cautious as we wait and see how this selloff plays out. Best case we’re overdue for a serious correction, worst case for a new cyclical bear market.
Interestingly which of these outcomes we face will become apparent through the speed of the selloff. Corrections in ongoing healthy bull markets are very sharp and front-loaded. The selling hits fast and furiously to quickly ramp up fear, so the SPX plunges. Corrections attempt to shake out as many bulls as quickly as possible to eradicate greed. The entire plunge approaching 20% takes only a couple months.
But new bear markets are vastly slower. Unlike corrections which are supposed to ignite fear, the mission of a young bear is to deceive stock traders into believing it doesn’t exist. So the selling is slow and mild, without any big VIX spikes. Bear markets are gradual to keep as many traders fully invested as long as possible, maximizing their damage. A long, slow, low-fear selloff greatly increases the odds a new bear is upon us.
Stock bears are hard environments to make money in. Sure you can short or buy puts, but these are very risky bets. The only sector that really tends to thrive when the stock markets are gradually getting cut in half over a couple years is gold. Gold has a strong history of powering higher during the cyclical bears of the past 14 years’ secular stock bear. It is one of the few asset classes inversely correlated with the SPX.
This was very evident last year, when the extraordinary stock-market levitation sucked capital away from all alternative investments including gold. As the overextended stock markets roll over as this selloff deepens, gold is going to make a big comeback in 2014. Owning it and the stocks of its elite miners are probably the best destinations possible for traders looking to multiply their wealth as the stock markets sell off.
Adam Hamilton is a CPA for Zeal Research. Zeal publishes Zeal Intelligence, a monthly enewsletter that details current stock and options trading strategies. For more info, see www.zealllc.com/subscribe.htm. To contact Adam, visit www.zealllc.com/adam.htm.