"What's happened here is an understanding that inflation is returning and that the central bank quantitative easing that we've grown accustomed to is coming to an end," said Jim Bianco, head of the Chicago-based advisory firm Bianco Research. In what amounted to the worst week in two years for the market the week, the benchmark S&P 500 Index and Dow Industrials both dropped 5.2% in the volatile week for stocks. The tech-heavy Nasdaq fell 5.1% while the small cap Russell 2000 lost 4.5%. In the chart below all of the major indices are in freefall and gold is approaching bear market territory.
A standard chart that we use to help confirm the overall market trend is the Momentum Factor ETF (MTUM) chart. Momentum Factor ETF is an investment that seeks to track the investment results of an index composed of U.S. large- and mid-capitalization stocks exhibiting relatively higher price momentum. This type of momentum fund is considered a reliable proxy for the overall stock market trend. We prefer to use the Heikin-Ashi format to display the Momentum Factor ETF. Heikin-Ashi candlestick charts are designed to filter out volatility in an effort to better capture the true trend. In the updated chart below the MTUM ETF confirms a market correction. The orange circle highlights extreme bearish momentum. Now the question will the current bearish move be contained to a “correction” and bounce back, or will there be a prolonged downtrend into bear market territory?
Put/Call Ratio is the ratio of trading volume of put options to call options. The Put/Call Ratio has long been viewed as an indicator of investor sentiment in the markets. Times where the number of traded call options outpaces the number of traded put options would signal a bullish sentiment, and vice versa. Technical traders have used the Put/Call Ratio for years as an indicator of the market. Most importantly, changes or swings in the ratio are seen as instances of great importance as this is commonly viewed as a change in the tide of overall market sentiment. Investors have become extremely bearish as indicated by aggressively buying put option contracts to provide protection against lower prices.
In the updated chart below, the dollar had its strongest week against a basket of currencies in nearly 15 months as some traders piled into the greenback in a week of tremendous swings felt in stock and bond markets around the world. The U.S. currency stemmed its protracted decline this week. Some traders have bought it to close out their bets on its weakness, while others favored the dollar in a safe-haven move over higher-returning but riskier currencies, analysts said. Spot gold was down 1% for the week for its second straight weekly drop due to the recovery in the dollar. Treasury yields experienced a volatile week that saw the yields hit four-year highs. The chart below demonstrates how treasury bond prices move lower as yields go higher and the dollar strengthens.
In the financial media it has been mentioned that in just 13 calendar days, from its January 26 closing high through Friday’s close, S&P 500 declined 10.2%—an official correction. Using a 20% peak to trough decline to define a bear market, the current bull market is 3260 calendar days old, nearly twice as long as average since 1949. The current bull is also the second longest, surpassed by only the great bull market that closed out the last millennium. The current correction is the fourth of the current bull market which is comparable to the numbers recorded by previous bull markets of similar duration.
An article posted by LPLResearch talks about how the Dow Jones Industrial Average and S&P 500 Index officially slipped into correction territory last week—marking the fastest move from record levels to correction in history. For reference, a correction is defined as a decline of -10.0% from the most recent high, which in this case occurred just nine days ago on January 26. The Dow has experienced two 1,000-point declines this week, which are larger numbers than investors are used to seeing on a single day; however, it is also important to note that the Dow is much higher now than it was the last time we experienced a significant pullback. The last time the Dow saw a larger percentage pullback in a single day was on August 8, 2011, when it fell 634.76 points to close at 10,809.85—a -5.5% move for the index. To put things in perspective, neither that move, nor the latest two drops (-4.6% and -4.1% on February 2 and February 8, respectively) managed to crack the top 100 declines in history. In the chart below, prior to last week, we have experienced 36 corrections since 1980, and the S&P 500 fell by an average of 15.6% from peak to trough during these periods. Twelve months later, the index made up some ground, rising an average of 16.0% from the low, and after 24 months, the S&P 500 had climbed by an average of 28.0%, reinforcing the need for long-term investors to maintain their diversified strategies. If this is just a run-of-the-mill correction, then we are looking at another four months of pain, history shows. If the losses deepen into a bear market (down 20 percent), then it could be 22 months before we revisit these highs, history shows. "The average bull market 'correction' is 13 percent over four months and takes just four months to recover," Goldman Sachs Chief Global Equity Strategist Peter Oppenheimer said in a Jan. 29 report.
Chief Investment Strategist John Lynch noted in a call to advisors, “it’s important to note that both interest rates and inflation remain low by historical standards, and this bout of volatility is more of a wakeup call for those investors who had grown complacent towards risk, as opposed to a sign of weakness in the broader economy.” On the contrary, as noted last week, economic data continue to point to solid and even accelerating growth, while corporate earnings are still expected to accelerate more than 10% over the balance of the year.
The CBOE Volatility Index (VIX) is known as the market’s “fear gauge” because it tracks the expected volatility priced into short-term S&P 500 Index options. When stocks stumble, the uptick in volatility and the demand for index put options tends to drive up the price of options premiums and sends the VIX higher. In the monthly chart below, the Volatility index exploded to its highest levels at well above it historical average of $20. You can see that option volatility spiked last week to the highest level since the summer of 2015 on the heels of daily triple-digit price fluctuations. Traders have stepped up buying protection in the option markets. Heavy volume continued this week and so far this year has set an accelerated pace for trading activity.
The American Association of Individual Investors (AAII) Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. The current survey result is for the week ending 02/07/2018. The percentage of individual investors expecting a decline in stock prices is at a three-month high in the latest AAII Sentiment Survey. At the same time, optimism is at a two-month low. Bullish sentiment, expectations that stock prices will rise over the next six months, plunged 7.7 percentage points to 37.0%. Optimism was last lower on December 7, 2017 (36.9%). The drop ends a streak of eight consecutive weeks with bullish sentiment above its historical average of 38.5%. Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rebounded by 1.5 percentage points to 28.0%. Even with the increase, neutral sentiment remains below its historical average of 31.0% for the 10th consecutive week. Bearish sentiment, expectations that stock prices will fall over the next six months, jumped 6.3 percentage points to 35.0%. Pessimism was last higher on November 16, 2017 (35.2%). The increase puts bearish sentiment above its historical average of 30.5% for the first time in nine weeks. The timing of when AAII members voted may have had an impact on the results. Email reminders to take the survey are sent out on Mondays, though members can take the survey at any time during the Thursday through Wednesday survey period. During the past three weeks, optimism has fallen by a cumulative 17.1 percentage points. Over the same period, pessimism has risen by a cumulative 13.6 percentage points. Such a shift is not unexpected given the market’s recent volatility and the recent streak of unusually high bullish sentiment readings. At current levels, all three sentiment indicators are within their historical ranges. Many individual investors have been expecting a return of volatility and/or a decline in stock prices. Some AAII members have previously described themselves as waiting for a market drop to provide a buying opportunity.
The National Association of Active Investment Managers (NAAIM) Exposure Index represents the average exposure to US Equity markets reported by NAAIM members. The blue bars depict a two-week moving average of the NAAIM managers’ responses. As the name indicates, the NAAIM Exposure Index provides insight into the actual adjustments active risk managers have made to client accounts over the past two weeks. The current survey result is for the week ending 02/07/2018. Fourth-quarter NAAIM exposure index averaged 70.97%. Last week the NAAIM exposure index was 55.58 %, and the current week’s exposure is at 56.80%. Last week’s commentary came to fruition were it was noted “…Money managers bailed out of equities to the lowest level since November. It is somewhat disconcerting that investors are not stepping in to buy the recent dip. This might be a signal of a longer term market correction…” As we pointed out last week, professional money managers had already started selling off equities. And the continued low NAAIM exposure level confirms that when retail investors joined in the selling last week, nobody was there to “buy the dip” and stop the bleeding. Expect the equity exposure to remain low as money managers rotated funds in treasury bonds and sent those prices soaring.
A recent article in the written by Jeff Hirsh in the Stock Trader’s Almanac mentions that the path to recovery from this correction could be slow, but it is only February 11th and over ten and a half moths remain in 2018. There is plenty of time for the market to finish the year with a gain. The positive implications of past big Januarys and a positive January Trifecta could still be realized. Lastly, the S&P 500 does not have a reliable track record when it comes to forecasting the next recession. Since June 15, 1948 there have been 11 S&P 500 bear markets and 24 corrections including the current one. Since the future is unknown, we will exclude the current correction meaning there have been 34 declines in excess of 10%. However, the National Bureau of Economic Research has only identified 11 recessions over the same time period. This works out to approximately 1 recession out of 3 S&P 500 declines in excess of 10%.
Last week we wrote “… if the market follows through with a correction…The next move is evaluate stocks on your watch list you might want to bid on if or when the market signals is time to start “buying the dips”. Until the market proves otherwise, buying stocks when prices pull back has been a very successful strategy the past few years…” In the updated graph below you can see that no major S&P sector escaped the carnage with energy stocks suffering the most.
This week American Association of Individual Investor (AAII) members were quizzed on what industries or sectors they currently like. One-third of all respondents (33%) said financial companies and banks. Nearly as many (31%) said technology. Health care, pharmaceuticals and biotech were named by 22% of respondents. Nearly 18% said industrial and materials companies. Energy was picked by 14% of respondents, while retail and consumer discretionary was favored among 12% of respondents. Many AAII members listed more than one industry or sector. In the current environment, if you have identified a price you would buy stocks on your “watch list” selling put options on those shares should be a good strategy. If you can find a put option strike price near were you would buy, if the stock falls below this level you get the stock at your bid, plus a small discount equal to the premium you sold. If the stock doesn’t fall to your bid price, that is okay because you still generated income from selling the put option.
Feel free to contact us with questions,
Senior Trading Strategist
The opinions and forecasts expressed herein are those of Mr. Gregory Clay and may not actually come to pass. Mr. Clay’s opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. The analysis provided is based on both technical and fundamental research and is provided "as is" without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.