Stock markets around the world got clobbered last week. The U.S. was down 5%-6%. Europe fell 5%-8%. China and nearby countries also dropped 5%-8%. Latin America was mixed, but still down 1%-8%.
Although pressures were clearly building, the catalyst for this week’s decline was concern over China’s economy, after it surprised the financial markets by devaluing the yuan. Other factors weighing on global markets in recent weeks include the relentless decline in the price of oil, concerns over the fallout from the expected move by the U.S. Federal Reserve to begin normalizing its benchmark Fed Funds rate and ongoing fears about the outlook for global economic growth.
From a technical perspective, the S&P 500 has more clearly entered a downtrend. The index sliced through two levels of support – around 2040 and also around 1985 – in just two trading days. After trading sideways for most of this year, the S&P has now moved to a lower low, which potentially sets up a new pattern of lower highs and lower lows.
Soon, traders will be talking about the “death cross” for the S&P 500, when the 50-day moving average crosses below the 200-day moving average. The Dow Jones Industrials suffered the same fate back on August 11.
Although the market has been trading sideways all year, there have been noticeable signs of deterioration in trading action for several months. The NYSE’s cumulative advance-decline line, a measure of market breadth, has been falling since May. Market leadership has become increasingly narrow, setting the stock market up for a tumble.
If history repeats, a correction might bring the market down 7%-12% from its peak. As of Friday’s close (8/21), the S&P is now down 7.7% from its May 20 intra-day high of 2134.72. In October 2014, during the last correction of consequence, the S&P 500 fell 9.8%.
Since the 2008 financial crisis, most corrections have been sharp and short-lived. Mr. Market often does not provide extended periods of base building that give us greater confidence that it is safe to jump back in. These quick corrections often follow a typical pattern: During Week 1, the market suffers its steepest decline. Week 2 is a period of consolidation when the market puts in its low and then rebounds. The uptrend is then reestablished more clearly in Week 3.
I don’t know whether this correction will follow that particular pattern. The textbook response to a steep decline like last week’s is to wait until the market stabilizes before buying again. Unfortunately, investors who have followed this approach have missed most opportunities in recent years to buy near the lows. The decision to buy shares early therefore clearly depends upon one’s tolerance of risk.
Those that are bearish point to the six-year bull market’s advanced age. This sell-off does have earmarks of a classic market top. The market still faces considerable risks that could lead to a more severe decline.
Even so, I do not believe that we are now witnessing the end of the bull market. Each of the three major concerns that have been offered as catalysts for the sell-off are, in my opinion, manageable:
- The imminent decision of the U.S. Federal Reserve to end its 0%-0.25% Federal Funds target rate. Even though inflation expectations remain well contained, it is not appropriate for an economy growing at 2%-3% with an unemployment rate at 5.3% to keep short-term interest rates near zero. In the current environment, there will never be a perfect economic backdrop for the beginning of the normalization process. The FOMC therefore needs to begin thinking about raising the bar on its data dependency.In recent weeks, declines in bond yields and Fed Funds futures have pointed to a lower probability of a September lift-off. If the FOMC does not move in September, then more of its members need to start agitating to get the process underway.A quarter point rise in the Fed Funds rate combined with a signal that the normalization process will extend over time will not prompt widespread selling in the financial markets. I believe that markets are well prepared and a rate hike is already priced in. A failure by the FOMC to take action will spark greater concerns over time.
- The decision by China to devalue its currency. China’s devaluation of the yuan has raised concerns that its economy is faltering. However, since China has for many years pegged its currency to the U.S. dollar, the yuan has risen sharply in tandem with the dollar against the currencies of many of its trading partners. Its decision to devalue is therefore a natural response to the pressures that an appreciating yuan has placed upon its exporters.The chart below shows that while the U.S. dollar (USD)/yuan (CNY) rate has been mostly flat, the Euro (EUR)/CNY and British pound (GBP)/CNY rates have risen markedly over the past year. (All rates indexed to 100 as of December 31, 2012.) At its peak in May 2015, EUR/CNY was up more than 23%.
By my calculations, CNY is also up sharply against the Brazilian Real (45%), the Mexican Peso (19%) and the Japanese yen (23%), all of which are major trading partners of China.China may indeed have other economic challenges that could justify investor concerns. However, its decision to devalue the yuan to relieve pressure on exporters seems reasonable and not by itself an ominous sign of problems in its economy. - The latest plunge in the price of WTI oil to around $40. Low oil prices could spark more defaults and bankruptcies among global corporate producers and raise currency and budget pressures on producing nations, but the process of adjustment in supply is well underway. With the decline in drilling activity to date and as hedges roll off in the second half of 2015, U.S. production will begin to drop more noticeably. The Saudis and other big producers may be intent on preserving market share, but they probably will not willingly wreck the oil market and their own economies in the process. Although it is difficult to predict when the price of oil will begin to recover, it is highly unlikely that oil prices will remain this low throughout 2016.
Beyond these catalysts, developing weakness in technical indicators, such as the narrowing of market leadership, have been well noted, but what looks like weakness from one perspective may also be laying the groundwork for the recovery. The extended decline in market breadth suggests that many stocks may have already experienced their corrections and are now better positioned for a rebound. Declines in market leaders (such as Netflix, Amazon and Facebook) could be a drag on the market, but other sectors of the market may begin to recover before a bottom becomes apparent in the major averages.
Most corrections since the 2008 financial crisis have been sharp and short-lived. Despite concerns, this one looks like it will follow the same pattern. Investors with a tolerance for risk should therefore begin nibbling on stocks that are in better shape technically and which now offer better value.