With recent indiscriminate investor selling, a look at five signs of a market correction
With the Nasdaq down about six per cent from its peak at the end of October, and the S&P 500 index down about four per cent in the same period, it is fascinating to watch investors’ behaviour recently. Even though the year has been solid, with the S&P 500 up about 13 per cent year-to-date, the Nasdaq up about 16 per cent and the TSX Composite up about 21 per cent, you would think that the world is ending if you were watching investors’ recent indiscriminate selling. For most of November, investors cared not one iota if corporate earnings were good or if interest rates were going down or if the United States government finally re-opened. They just wanted to sell, and sell they did. Some stocks have fallen 30 per cent in November. So, is this the end of the market party or just a regular correction? Let’s take a look at five signs of a market correction and where we might stand now.
Extended distance above moving averages
For the technical analysts amongst us, the S&P 500 has, prior to Thursday’s market, traded above its 50-day moving average for an exceptionally long streak (more than 130 trading days). This often signals an “overbought” condition that historically precedes corrections. With the past week’s decline, it is now below the 50-day moving average, with the 200-day moving average at the 6,000 level, meaning a correction could pull the index back towards these support levels. This could imply further declines, if you believe strongly in technical indicators.
High valuations (relative to historical averages)
A lot has been said about valuations in the current market. The S&P 500 is trading around 2.3 standard deviations above its historical trend line, indicating some overvaluation. Models show the index is about 82 per cent above its modern-era historical average, which can often be a mean-reversion warning sign. Still, as discussed in my column about bubbles, there are legitimate reasons why higher valuations might not foretell a problem in the market. Still, for the nervous investors out there, valuations are viewed as worrisome. Of course, in such scenarios, we at 5i Research Inc. always like to point out that the buyers of stocks today do not see valuations as an issue. Buyers, of course, are not buying today with the intention of losing money.
Weakening momentum
Technical indicators such as bearish divergences in momentum oscillators are present, and the market rally, as most are aware, has become concentrated among fewer stocks, such as the Magnificent Seven. While recent technical analysis still shows “buy” signals across most short- and mid-term measures, longer-term momentum oscillators, such as relative strength index (RSI) and moving average convergence divergence (MACD), are levelling off, which typically foreshadows increased volatility and risk of reversal. Again, technicals are not always right and fundamental positive news such as lower interest rates, lower inflation or solid corporate earnings can quickly override technical indicators at any time.
Increased margin debt
As I discussed in October, the current market environment features record margin debt levels, which can accelerate sell-offs during corrections. This kind of leverage has been noted in major Wall Street warnings, suggesting susceptibility to sharper drawdowns if sentiment turns negative. But again, there are reasons for higher debt levels, and we do not think they, in isolation, are the issue. However, any investor using margin knows full well that anxiety and fear in a market correction increases if you owe a lot of money, and this can of course result in much higher volatility when a correction occurs.
Signs of sector rotation and narrow leadership
Leadership in the S&P 500 rally has become highly concentrated, a phenomenon frequently seen before corrections. Sector rotation into defensive segments, or fewer stocks driving the index higher, is a traditional signal of underlying risk. We have noticed this this week, as our Members at 5i Research have been increasing their inquiries about “safe” stocks and dividend stocks, and we’ve had lots of questions along the lines of, “Is it time to take profit in the tech sector?” But we are not convinced that narrow leadership is a problem in this market cycle. In the artificial intelligence field, the largest companies have a huge advantage, as they have the financial capacity to pour into research and development initiatives. As they invest, their “moat” can get larger, and it becomes more difficult for smaller companies to compete. In such instances, larger companies should get higher valuations.
So, are we in a correction, or is something far worse looming? As usual, no one knows. But, we’ve seen this all before. To us, it appears — so far at least — that this is just a normal market correction. Fund managers are locking in gains. Individual investors are making tax-loss sales. Pension plans are positioning for year-end reporting. A five per cent correction after 20 per cent gains is nothing to panic about. The two things that really count — corporate earnings and interest rates — continue to move in the right direction, and we do not think long-term investors need to panic right now. Panic, of course, is never a good market strategy.
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