US stocks declined for the seventh straight day on Friday, a dismal streak not seen for almost four years. The S&P 500 is now down 5 of the last 7 weeks although in total it is just 2.5% below the all time high. If you just own the index I suppose that is not much to be concerned about but there are warning signs galore. The S&P 500 is also basically unchanged in price for now over 8 months dating back to late November of 2014. That might not be a correction in price according to the accepted definition but it probably qualifies as a correction in time. And if you own anything other than the index you are probably suffering your own personal correction as the index itself only tells part of the story.
I don’t know who decided that a correction would be defined as a drop of 10% but less than 20% (that being the bear market line in the sand) but it seems rather narrow to me. If a bull market is one where most stocks are rising then what do we call one where that isn’t so but it hasn’t fallen 10%? If one defines rising as above the 200 day moving average (another one of those widely accepted definitions) then the S&P 500 is barely hanging on to bull market status with about 54% of the index above that line.
Unfortunately, most other indexes show a majority of their constituents below that magic barrier. Despite all the recent hoopla about record highs, only 43% of NASDAQ stocks are still in uptrends. The NYSE fares even worse with just 39% moving higher. The small cap indexes have done even worse than their large cap counterparts; the Russell 2000 is no higher now than it was in March 2014, 5 quarters ago. So, I don’t know if we call it a correction but by time and price the individual constituents of the stock market indexes are not faring nearly as well as the indexes themselves. That is a result of using capitalization as a weighting factor, with the largest stocks having the greatest influence over the index.
Unfortunately for the bulls, we are finally starting to see some cracks in those largest stocks this earnings season. Disney was only the latest victim last week but we’ve been seeing a generally negative reaction to anything but the best of earnings reports. The OEX (S&P 100; the largest 100 of the 500) now has just 57% of its members above the 200 day MA, down from 81% as recently as May.
Momentum also points to correction with bonds outperforming most stock indexes over the last three months. In particular, long term Treasury bonds have moved to the head of the momentum class while junk bonds, emerging market stocks and commodities bring up the rear. Large cap stocks, domestic and international, are stuck right in the middle – and trending down the rankings. High quality bond outperformance is a transition that started, believe it or not, way back at the beginning of 2014 and after correcting for most of this year, appears to be reasserting itself. Bond outperformance is a function of the ongoing commodity rout which is dragging down inflation expectations and pushing down commodity (oil) and materials stocks.
The recent economic data certainly hasn’t been that encouraging to the bulls – or the bears for that matter. The US economy will have a hard time reaching even the recent lousy trend of 2 to 2.5% this year. It isn’t impossible for the economy to accelerate in the second half and get to that level; that’s what happened the last two years. The biggest impediment to that is probably the inventory picture which is quite a bit worse now than it was in 2013 or ’14. Merchants have played this game for two years in a row now – stock up in anticipation of an economic acceleration that never comes – and I have my doubts as to whether they will do so again. But something worse? Recession? I don’t see it right now. And I think that’s what we would need to see to get something in excess of a correction, a bear market.
Last week’s employment report was just one more in a string of demoralizingly mediocre economic reports that reinforces and supports the New Normal/Secular Stagnation theme. If we talk about secular stagnation enough, if we continue in this rut of lousy growth for long enough, if we spend our time arguing about how to move money from that rich guy’s pocket to this poor person’s pocket, if pundits mock anyone who has the audacity to say that better growth is even possible, does slow growth – or worse – become a self-fulfilling prophecy? This isn’t the New Normal; it’s the New Malaise. I don’t think we’ll see growth above the recent range for more than a quarter or two here and there absent major, radical changes in all economic policies – monetary, fiscal and regulatory. And that is not going to happen in the 16 months leading up to a Presidential election.
While right now neither better, faster growth nor recession seems likely, the action in credit markets should give one pause. The shale bust is returning, with new stresses emerging as hedges expire and companies get exposed to today’s low, consumer friendly prices. High yield credit spreads are moving wider again (in fact rapidly enough to trigger a sell signal in our asset allocation model) and while energy companies are the proximate cause, the damage is not confined to that sector.
Non-energy credits are now facing higher rates as well. I have previously noted but will point out again that it isn’t just junk bonds where spreads are widening. Baa bond spreads have been moving steadily wider and are now at levels associated with past recessions. Even AAA spreads are wider than they were in the last expansion. The Fed may be considering tightening at the September meeting but they are, as usual, well behind the market where corporate borrowing rates have already moved higher – in absolute as well as relative terms – since the spring.
According to the normal definition, we haven’t even entered correction territory yet but there is a sort of stealth version going on already. That can also be seen in the measures of market sentiment which have cooled off considerably the last few months. Less than a quarter of the AAII poll respondents count themselves as bullish and other surveys show similar, if not so extreme, movements. Of course, there aren’t many bears either; the largest contingent calls themselves neutral. The point is that people don’t just suddenly turn bearish or even neutral when the bull market is romping. They stay bullish and the market keeps going up until we’ve converted all who can be to the bullish camp. Whether we get a correction – a real one that meets all definitions – depends on where those neutral voters go. If they turn outright bearish, we’ll probably get that correction. If they go the other way, then we won’t. Right now, momentum seems to be building for the former.
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