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The Markets This Week

February 12, 2018 | Weekly Commentary

So that’s what a correction feels like. Yes, it was painful, but there was a curious sensation about this one.

It’s been a long time since we’ve experienced a drop like we did last week. The Dow Jones Industrial Average tumbled 1330.06 points, or 5.2%, to 24,190.90 last week, its worst since Jan. 2016. The Standard & Poor’s 500 index slumped 5.2% to 2619.55. The Nasdaq Composite dropped 5.1% to 6874.49. On Thursday, both the S&P 500 and Dow had dropped more than 10% from their Jan. 26 high, the definition of a correction, though they made back some of those losses in a late-Friday rally.

And what a strange correction it has been. Unlike the past ones since the end of the financial crisis, this correction was caused by fears of too much growth, rather than concerns that there wouldn’t be enough. When the S&P 500 tumbled 13% from Nov. 3, 2015, through Feb. 11, 2016, it was caused by a collapse in oil prices that then spread into high-yield bonds, raising the specter that a recession was looming. Not this time. Economic data continue to come in strong—the Atlanta Fed’s GDPNow indicator estimates 4% growth this quarter—while companies continue to report strong earnings and give upbeat guidance even when the benefits of tax cuts are excluded. Even the high-yield bond market is refusing to act as if a crisis is at hand.

Sure, we can cite a litany of reasons for the correction. The market was overbought and overvalued. Investors had misjudged inflation and miscalculated how high bond yields could go. But really, we were just overdue. Too many traders had bet the market’s calm would last forever. It’s probably the most overused statistic about this market, but the S&P 500 had gone more than a year since its last drop of 5% or more.

So, a correction is what we got—and an uncomfortable one, just like it’s supposed to be. “They should be painful,” says Thomas Digenan, Head of US Intrinsic Value Equities at UBS Asset Management.

Still, the market needs a narrative—and so it’s latched on to whatever’s handy, in this case that the Fed is so far behind the curve that inflation will spike and bond yields will soar. As with many good stories, there’s a kernel of truth to this one. Inflation is picking up, bond yields are heading higher, and the Fed is behind the curve, says Richard Bernstein, chief investment officer at Richard Bernstein Advisors. Many had been reluctant to embrace that idea. Now they may have no choice. “The employment report destroyed the narrative that there would never be inflation again,” says Bernstein, who doesn’t foresee the correction becoming a bear market. “And that caused chaos at this point.”

History suggests that this correction isn’t the end of the bull market, despite the chaos. Part of that has to do with what came before the rally—a long period of what market technicians call consolidation.

From May 19, 2015, through July 11, 2016, a period that included a correction, the Dow went nowhere, explains Randy Watts, chief investment strategist at research shop William O’Neil. The next day, the benchmark hit a new high, and the Dow went on to gain 45% over the next 80 weeks.

Watts sees more similarities to a breakout that occurred in 1995. It occurred well into a bull market—just like the current one—and gains have been similar at the same period of time. And each of those initial rallies came with no hiccups—neither had even a 5% drop before their first correction. That bull market ended up running for 255 weeks, with the Dow nearly tripling during the same period. If the Dow follows that pattern, there could be more upside ahead.

Trading action suggests that the market could be close to finding a bottom. After hitting a new all-time high on Jan. 26, the S&P 500 had tumbled through its 20-day moving average a week later, and then through its 50-day on Monday. When the S&P 500 ticked below its 200-day moving average early Friday afternoon, it looked like that wouldn’t hold either. Instead, a furious rally ignited and the index finished up 1.5%. “At least it respected one technical level,” says Fundstrat technical analyst Robert Sluymer.

That doesn’t mean that the 200-day will hold again on Monday, but there’s no reason to call the end of the bull market just yet. Even Stifel Head of Institutional Equity Strategy Barry Bannister, who correctly called the correction last month, doesn’t foresee it becoming a bear for the simple reasons there’s no recession in sight.

Does that mean it’s time to rush in and buy everything in sight? No. Bannister expects a bottoming process, not a V-shaped bounce. And it might take a higher inflation print—the consumer price index is being reported on Wednesday—and a 3% yield before investors feel that the worst is over. “It could be a capitulatory moment for the stock market,” Bannister says.  Unless we’ve already had it.

(Source: Barrons Online)

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