Stock Selloff Starts

Selling has finally returned to the US stock markets, short-circuiting their year-old levitation.  This new downside action of the last couple weeks looks very different from anything witnessed in 2013.  Is it just another minor and short-lived pullback, the vanguard of a full-blown correction, or the dawn of a new cyclical bear market?  The prudent strategy for traders varies greatly with this selloff’s likely magnitude.

Selloffs are a normal, healthy, and necessary stock-market behavior.  They are absolutely essential to rebalancing sentiment.  The longer and farther markets rally, the more greed and complacency capture traders’ hearts.  Their usual cautiousness vanishes, and they race to pour capital into increasingly toppy markets.  But this greed soon grows unsustainable and burns itself out once all near-term buyers are in.

The only way to entice in new capital and keep the markets climbing on balance is to bleed off the excess greed.  Enter the selloff.  When stocks start falling, the great sentiment pendulum starts swinging back from the greed extreme of its arc towards the opposite fear end.  Eventually as the selloff matures, stock prices are low enough and fear is high enough to attract new buyers.  Then stocks start climbing again.

2013’s extraordinary stock-market levitation didn’t see normal selloffs, which is the main reason it was so troubling for veteran traders.  And that is why the last couple of weeks feel so different.  Normal healthy bull markets experience 3 or 4 pullbacks per year, selloffs in the benchmark S&P 500 stock index (SPX) that run from 4% to 10%.  That actually did happen last year, there were plenty small pullbacks in 2013.

But these minor selloffs don’t bleed off much greed, making much larger correction-magnitude selloffs necessary from time to time.  These ultimately run between 10% and 20%, and eradicate a great deal of greed.  They happen about once a year in healthy bull markets, and 2013 absolutely should have seen one.  The longer stock markets climb without a full-blown correction, the greater the odds one is imminent.

Incredibly, it’s been a whopping 27.5 months since the end of this cyclical bull’s last correction!  That is more than double the normal span.  This fact alone certainly swings the probabilities wildly in favor of today’s nascent selloff ultimately extending into correction territory beyond 10%.  And since it has been so long, the next correction is much more likely to weigh in closer to the 20% upper limit than merely 10%.

Unfortunately 2013’s one-sided levitation lulled speculators and investors into such deep complacency that most have forgotten how brutal real corrections are.  This first chart superimposes the SPX levitation since late 2012 on top of the premier stock-market fear gauge, the VIX.  The VIX is an essential indicator for gaming corrections, since they only end after fear flares dramatically as measured by big VIX spikes.

From its mid-November 2012 low after Obama’s reelection to its latest nominal record high in mid-January 2014, the flagship SPX blasted 36.6% higher in just 14 months!  In 2013 alone, the SPX was up 29.6%.  This was more than triple the SPX’s long-term average annual returns around 9.5%.  Such big gains stuffed into such a short period of time should have triggered a correction, but one didn’t happen.

The reason is the fabled Fed Put.  Stock traders believed the US Federal Reserve would greatly ramp up its money-printing debt-monetizing QE3 campaign in the event of any material stock-market selloff.  With the perception that the Fed had traders’ backs, there was no need to worry about normal stock-market indications of overboughtness and hence imminent selloffs.  Traders just immediately bought every dip.

The result of all this central-bank meddling in normal stock-market cycles is the one-sided levitation in this chart.  While there were plenty of selloffs, none evolved beyond the small-pullback stage.  And half of them didn’t even reach the 4% pullback threshold!  Briefly going through them offers some essential context for understanding today’s nascent selloff.  The first in this levitation came in December 2012.

That was when late 2012’s so-called fiscal cliff approached, and it looked like the US Congress was at an insurmountable impasse.  Still, the SPX only drifted 3.1% lower over 7 trading days.  The Fed had launched QE3 a few months earlier in September 2012, and more than doubled it that very month of December 2012.  Stock traders figured there was no need to sell since the Fed could expand QE3 again.

In late February 2013, another selloff began cascading on European fears.  The Italians almost voted in a political party ready to default on Italy’s gargantuan national debt.  And Italy is the world’s third-largest debtor nation, so the shockwaves that would unleash on fragile European banks would be catastrophic.  But with the Fed Put in place, American stock traders capped that selloff at a mere 2.8% in 4 trading days.

In mid-April the SPX again dropped 3.2% in 5 trading days, this time stock traders were spooked by the precipitous panic-like plummet in gold.  But gold soon bounced as the futures forced liquidations ran their course, and the SPX followed.  Within a couple of weeks, the SPX would be back up to new record highs.  Again with the Fed’s massive QE3 inflation effectively backstopping stocks, why bother selling?

The levitation’s first real pullback arrived in mid-May and cascaded into late June.  The lion’s share of that came after Ben Bernanke gave a post-FOMC-meeting press conference where he laid out the best-case timeline for starting tapering the QE3 debt monetizations.  This helped hammer the SPX down 5.8% in 23 trading days, but it was still far from a correction.  It was too shallow to break the euphoria, so rallying soon resumed.

The next pullback arrived in August on reports of weak retail sales.  The US stock markets were getting very expensive by all valuation metrics, and without earnings growth those stock prices simply wouldn’t be sustainable.  This pullback weighed in at 4.6% over 17 trading days.  But again with the Fed on the case, American stock traders were soon buying again.  They actually started to embrace the QE3 taper.

It was universally expected to start at the FOMC’s September meeting, as Fed officials had been working overtime to set that expectation.  So when the Fed surprised and decided not to start slowing its bond buying, stock traders figured the Fed must think the US economy was still too weak to weather the shock of QE3 tapering.  So the SPX pulled back again, but barely at 4.1% over 14 trading days.  And that was it.

After that theatrical partial government shutdown ended in mid-October, the US stock markets were off to the races for the rest of the year.  The average of the 5 material selloffs the SPX experienced in 2013 was just 4.1%, barely pullback-magnitude.  The lack of natural sentiment-rebalancing selloffs worked to breed extreme hubris.  Traders came to believe stocks were so awesome that they would never correct!

With stocks powering higher so dramatically last year, stock-price gains far outpaced earnings growth.  This drove stock valuations to lofty bull-slaying extremes by late last year.  More and more traders started to realize stock prices weren’t sustainable unless earnings soared to justify some of 2013’s massive gains.  So the critical Q4 holiday earnings season became very important for stock traders’ sentiment.

And as January 2014 rolled through, these Q4 results were generally weak.  Though profits were beating lowered-expectations bars, they were often lower than a year earlier.  And sales were definitely down, an ominous omen.  Cost cutting, firing people, can only boost earnings for so long.  If businesses can’t grow sales, they can’t grow earnings over the long term and can’t support and justify lofty stock prices.

Though the SPX had stalled in January, the recent bout of selling didn’t start until near the end of last month.  Chinese factories were reporting contraction, they were shutting the doors and sending workers home because there was insufficient demand.  And with China’s factories making stuff for Americans and Europeans to buy, this implied weakening consumer demand and consumer health here in the US.

And then emerging-market fears started to mount too.  Argentina had to abandon defending its faltering currency, while Turkey’s central bank hiked its overnight lending rate by 425 basis points to 12.0% to attempt to stave off a mass exodus out of its own currency.  All this happening together was finally enough to shock greedy stock traders from their complacent slumber.  They finally started selling again.

The result so far is a nascent 5.8% selloff over 12 trading days ending this past Monday.  Though its latest low makes this pullback the same size as the June one on that QE3-tapering scare, this one happened in half the time!  Thus it is much more severe and very different from anything witnessed last year.  Yet despite its considerable size by 2013’s low standards, this selloff remains small in the grand scheme.

The SPX last topped at 1848 on January 15th.  So to merely get to the 10% correction threshold, the SPX would have to fall to 1664.  That’s a long ways down from here!  It would drag this index back down near its early-October lows, as the 10% line in the chart above shows.  Considered another way, the SPX first hit 1664 in mid-May.  So just a garden-variety 10% correction would effectively erase all gains since May!

But that mid-January high was 27.5 months after the SPX’s last correction, far beyond the once-a-year average.  So again the odds favor the next correction being considerably larger than 10%.  A 15% retreat in the SPX would drop it to 1571, a level first seen in early April and then again near the bottom of the large QE3-tapering-timeline June pullback.  15% would erase about 2/3rds of the SPX levitation’s advance.

And finally check out that lower 20% line, a full-blown correction.  To fully rebalance sentiment and give this bull any chance of powering higher again, the SPX would have to fall 20% from its recent high to 1479.  It first hit these levels in mid-January last year, so a large correction would nuke virtually all of 2013’s outsized gains!  That is hard to imagine, and I bet most stock traders haven’t even considered it.

Corrections are major nontrivial events that slaughter the unwary.  They slash stock prices dramatically enough to bleed away all greed and rekindle widespread fear.  Today’s stock traders, coddled by the Fed Put last year, are not prepared to weather a correction-magnitude selloff.  It would no doubt break them psychologically, which means any major selloff might have a big problem conveniently stopping by 20%.

All year long hardcore contrarians like me warned that the stock markets’ giant gains were certainly not fundamentally justified.  They were just the result of the Fed manipulating trader psychology through its gigantic debt monetizations.  So as the Fed continues to taper QE3 in 2014, and stock markets continue to sell off, it is really going to rattle euphoric stock traders.  Their selling will feed on itself and intensify.

So while a large high-teens correction is the absolute minimum SPX selloff we need to see, there is a very good chance it will edge through 20%.  Anything above 20% is bear territory.  And once a new cyclical stock bear is underway, stock prices are usually cut in half before a new cyclical bull is born.  This final chart zooms out to today’s entire cyclical stock bull.  And it is wildly overextended by any standard.

In the 4.9 years between March 2009 and January 2014, the flagship S&P 500 powered an extraordinary 173.2% higher!  This is far beyond the average size and duration of mid-secular-bear cyclical bulls of a doubling in 34.8 months.  Our current epic specimen was at 58.3 months in mid-January, way too old.  Provocatively the last cyclical bull that topped in October 2007 hit 60.0 months when it gave up its ghost.

Cyclical stock bulls rarely last much longer than 5 years, and we are right there.  Today’s bull was actually totally normal before 2013’s crazy distortions from the Fed Put.  It climbed in a normal horizontal parabolic trajectory (see yellow line above), with sharp initial gains tapering off as it matured.  It experienced a 16.0% correction starting 13.5 months into the bull, and a major 19.4% one 9.9 months after the first ended.

Everything made sense, the stock markets were very tradable, and they weren’t euphoric.  But the reckless Fed ignited a decoupling from this healthy normalcy in early 2013.  Right when the overextended SPX should have been correcting, it broke out above its normal rallying curve.  Provocatively a 20% correction would merely take this index back to that normal curve, which still isn’t low by any stretch of the imagination.

Though the ridiculously-too-long 27.5-month span since the end of the last correction is very clear above, some stock bulls love to point out a near-correction in mid-2012.  Indeed the SPX fell 9.9%, which certainly rounds to 10%, over 42 trading days.  But even crediting that as a correction really doesn’t help the bulls at all.  Since its end, it has still been 19.5 months since the last correction, which is still far too long.

Remember the whole purpose of corrections is to rebalance sentiment, to bring prevailing fear.  That is evident through the VIX implied-volatility index on stock-index options traders’ collective bets.  The higher this gets, the more scared traders are.  Full-blown corrections don’t end before the VIX spikes well over 40!  The serious fear ignited by this bull’s two previous corrections are sure evident in their VIX spikes.

The past couple weeks’ selloff, despite its sharpness, has merely pushed the VIX back up near 21.  This isn’t much higher than it was during 2013’s minor pullbacks, which suggests sentiment rebalancing and hence selling has a long ways to go yet.  Stock traders are taking big and unnecessary risks if they buy stocks before we see an outsized VIX spike.  Before that, any short-covering relief rallies should soon peter out.

With this cyclical bull massive beyond belief, and the stock markets still technically mired in the sideways-grinding secular bear that was born in early 2000, and stock valuations up near toppy bull-slaying extremes, smart speculators and investors should be very cautious as we wait and see how this selloff plays out.  Best case we’re overdue for a serious correction, worst case for a new cyclical bear market.

Interestingly which of these outcomes we face will become apparent through the speed of the selloff.  Corrections in ongoing healthy bull markets are very sharp and front-loaded.  The selling hits fast and furiously to quickly ramp up fear, so the SPX plunges.  Corrections attempt to shake out as many bulls as quickly as possible to eradicate greed.  The entire plunge approaching 20% takes only a couple months.

But new bear markets are vastly slower.  Unlike corrections which are supposed to ignite fear, the mission of a young bear is to deceive stock traders into believing it doesn’t exist.  So the selling is slow and mild, without any big VIX spikes.  Bear markets are gradual to keep as many traders fully invested as long as possible, maximizing their damage.  A long, slow, low-fear selloff greatly increases the odds a new bear is upon us.

Stock bears are hard environments to make money in.  Sure you can short or buy puts, but these are very risky bets.  The only sector that really tends to thrive when the stock markets are gradually getting cut in half over a couple years is gold.  Gold has a strong history of powering higher during the cyclical bears of the past 14 years’ secular stock bear.  It is one of the few asset classes inversely correlated with the SPX.

This was very evident last year, when the extraordinary stock-market levitation sucked capital away from all alternative investments including gold.  As the overextended stock markets roll over as this selloff deepens, gold is going to make a big comeback in 2014.  Owning it and the stocks of its elite miners are probably the best destinations possible for traders looking to multiply their wealth as the stock markets sell off.

The bottom line is a new stock-market selloff is underway.  And after 2013’s extraordinary levitation, the odds are very high it needs to grow into a correction-magnitude event to rebalance sentiment.  A full-blown correction would totally erase nearly all of last year’s gains, which would certainly be catastrophic to trader psychology.  And a large correction is virtually assured since it has been so long since the last one.

But that might not be enough.  Today’s cyclical stock bull is nearly 5 years old, and wildly oversized.  On top of that, stock valuations have surged to dangerous bull-killing extremes.  So the next cyclical bear is much more likely than a mere correction.  This would cut stock prices in half over a couple years!  The best way to weather it will be in gold, which is inversely correlated to the SPX and overdue to rebound strongly.

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At Zeal we specialize in contrarian speculation and investment, a rare and essential perspective these days.  For well over a decade we’ve published acclaimed weekly and monthly subscription newsletters.  In them I draw on our hard-won experience, knowledge, wisdom, and ongoing research to explain what is going on in the markets, why, and how to trade them with specific stock trades.  All this expertise is offered for just $10 per issue, so you ought to join us today and prepare for the SPX selloff!

Adam Hamilton, CPA

February 7, 2014

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