Post by Conrad Alvin Lim on Nov 24, 2006 5:41:12 GMT -4
The Big Picture
Analysis of major issues.
Updated: 20-Nov-06 10:55 ET
Is the Market Due for a Correction?
This is one of the longest bull market runs without a major correction. Chart analysis suggests one is due. If that does happen, however, it may ultimately prove a buying opportunity.
The Facts
The current bull market began in October of 2002. That was when the bear market of 2000-2002 ended when the S&P hit a cyclical low of 769. Since then, the S&P 500 has risen 81% in a little over 49 months.
The market was choppy through May of 2003, but since bottoming, there has not been a market sell-off of 10% or more. That is the degree of retracement that most technical (chart) analysts would call a correction. (A decline of 20% or more is usually termed a bear market.)
Corrections are considered healthy to a long-term bull market, as they allow for pent-up bearish sentiment to be released.
In addition, the S&P 500 has made a spectacular run since July 19 of this year. In just four months, the index has risen 14%. During that period, the index has not had a correction of as much as 2.5%. Many technical analysts feel that a correction is long overdue.
Perceptions Can Shift Quickly
Corrections are typically set off by a change in attitude towards a key fundamental. As much as anything, this simply allows any latent bearish sentiment to be released, and for the desire for profit-taking to manifest itself.
When a correction sets in, bearish sentiment takes hold and becomes dominant. It is then easy to forget just how strong the underlying fundamentals might be, and how much the bearish sentiment might be based purely on emotion.
For example, when the price of oil was rising above $70 a barrel a few months ago, there was widespread talk that $100 a barrel oil was a near certainty. To suggest otherwise was considered wishful thinking or even sheer lunacy. When the stock market dipped in May of this year, it was in large part because of widespread concerns that the Fed would have to raise rates at least one more time, and there were concerns that such action might lead to a recession. There is a chance that a similar shift in perceptions towards one of the key fundamentals could spark a stock market correction in the near term.
The Usual Suspects
The key fundamentals are noted below, with associated risks that a change in perception will occur.
Interest rates: It is highly unlikely that a change in perception here leads to a correction. Market expectations are rightfully fixed for no change in Fed policy into early next year, and the next move in policy is likely to be towards lower rates.
Inflation: There is only an outside chance that inflation picks up and sparks a correction. There has been an easing trend in inflation rates over the past six months, and it would take more than one month of a strong number to alter perceptions. Oil prices and commodities are well off their highs. Inflation is an unlikely suspect to produce a quick swing in expectations that would spark a correction.
The economy: It is possible that a shift in the economic outlook initiates a correction. The economic focus at this time of year is always consumer spending trends for the holiday season. Typically, the talk in November and early December is that sales are weak, and below forecasts. The past several years this has been the case. If there is any weak data it is possible that fears spread quickly about a sharp slowdown in consumer spending that sets off (unwarranted) fears of a recession.
Earnings: This is a viable candidate for a significant view shift over the next several months. The stock market has become unrealistically accustomed to double-digit earnings growth every quarter. That can't continue. Earnings growth over the long run tracks nominal GDP. That has risen about 6% over the past year. Companies will reach a point when they can no longer raise profits at a faster clip than revenue. It is possible that once earnings forecasts start coming down, fears of declining profits will spark a market correction.
Domestic and Global Politics: This is a difficult risk to assess, but deserves mention. The market has handled geopolitical risks with aplomb in recent years, but if the market is primed for a correction, an event could spark selling. Domestically, there could be a shift in perceptions from the value of gridlock to concerns about a revival of trade protectionism, as well as possible anti-profit oriented initiatives towards the oil and pharmaceutical sectors.
Bottom Line Fundamentals
A correction is often called healthy for a bull market. Yet, it is very hard to remember that while the price of every stock one holds is going down, and there are analysts proclaiming the start of a new bear market.
Yet, if the fundamentals do not significantly change, a correction would indeed provide a buying opportunity.
It is important to remember that the fundamentals remain bullish, and are likely to remain so, for the following reasons:
1) Valuations are very reasonable. The S&P 500 trades at just 16.3 times trailing operating earnings. That is a 6.1% earnings yield that compares very favorably to bond yields.
2) Economic growth will continue despite possible dire statements about consumer spending and the housing market. Real incomes are rising due to strong employment growth, a pick-up in wage growth, and low inflation. Business investment trends are strong. A few bad days of consumer spending or reports that the day after Thanksgiving was not great for Wal-Mart does not mean a recession is imminent.
3) Earnings growth, even if it drops to 5%, will provide fuel for further stock gains. If the P/E holds steady, 5% earnings growth will lead to a 5% gain in the stock market. The shift in view from 10% growth to 5% could, however, produce initial disappointment.
What It All Means
A correction over the next several months is very possible. It could well come in the first quarter after the traditional year-end market strength. Or, it could come earlier if the market anticipates such concerns.
A correction could be sparked by a limited amount of data on a key fundamental that is in fact insufficient to alter the underlying trend but nevertheless brings latent fears to the surface. Extrapolating dire consequences from a very limited amount of data points is a time-honored market tradition. It can happen at any time.
Yet, keeping a cool head during a correction will present buying opportunities. That is easy advice to write, but not so easy to follow. In July, when market sentiment was very poor, our view was turning more bullish. Yet, we did not move our Market View back to moderately bullish until August in part because it was so hard to fight the prevailing sentiment.
The market can't go straight up forever. A correction is very possible over the near term. Yet, the underlying trends in the economy, earnings, and interest rates remain distinctly bullish. Unless there is a significant alteration in any of these, a correction would prove exactly what it is defined to mean - a temporary market set-back.
The market is indeed due for a correction, but until the fundamentals change this is still a bull market.
Analysis of major issues.
Updated: 20-Nov-06 10:55 ET
Is the Market Due for a Correction?
This is one of the longest bull market runs without a major correction. Chart analysis suggests one is due. If that does happen, however, it may ultimately prove a buying opportunity.
The Facts
The current bull market began in October of 2002. That was when the bear market of 2000-2002 ended when the S&P hit a cyclical low of 769. Since then, the S&P 500 has risen 81% in a little over 49 months.
The market was choppy through May of 2003, but since bottoming, there has not been a market sell-off of 10% or more. That is the degree of retracement that most technical (chart) analysts would call a correction. (A decline of 20% or more is usually termed a bear market.)
Corrections are considered healthy to a long-term bull market, as they allow for pent-up bearish sentiment to be released.
In addition, the S&P 500 has made a spectacular run since July 19 of this year. In just four months, the index has risen 14%. During that period, the index has not had a correction of as much as 2.5%. Many technical analysts feel that a correction is long overdue.
Perceptions Can Shift Quickly
Corrections are typically set off by a change in attitude towards a key fundamental. As much as anything, this simply allows any latent bearish sentiment to be released, and for the desire for profit-taking to manifest itself.
When a correction sets in, bearish sentiment takes hold and becomes dominant. It is then easy to forget just how strong the underlying fundamentals might be, and how much the bearish sentiment might be based purely on emotion.
For example, when the price of oil was rising above $70 a barrel a few months ago, there was widespread talk that $100 a barrel oil was a near certainty. To suggest otherwise was considered wishful thinking or even sheer lunacy. When the stock market dipped in May of this year, it was in large part because of widespread concerns that the Fed would have to raise rates at least one more time, and there were concerns that such action might lead to a recession. There is a chance that a similar shift in perceptions towards one of the key fundamentals could spark a stock market correction in the near term.
The Usual Suspects
The key fundamentals are noted below, with associated risks that a change in perception will occur.
Interest rates: It is highly unlikely that a change in perception here leads to a correction. Market expectations are rightfully fixed for no change in Fed policy into early next year, and the next move in policy is likely to be towards lower rates.
Inflation: There is only an outside chance that inflation picks up and sparks a correction. There has been an easing trend in inflation rates over the past six months, and it would take more than one month of a strong number to alter perceptions. Oil prices and commodities are well off their highs. Inflation is an unlikely suspect to produce a quick swing in expectations that would spark a correction.
The economy: It is possible that a shift in the economic outlook initiates a correction. The economic focus at this time of year is always consumer spending trends for the holiday season. Typically, the talk in November and early December is that sales are weak, and below forecasts. The past several years this has been the case. If there is any weak data it is possible that fears spread quickly about a sharp slowdown in consumer spending that sets off (unwarranted) fears of a recession.
Earnings: This is a viable candidate for a significant view shift over the next several months. The stock market has become unrealistically accustomed to double-digit earnings growth every quarter. That can't continue. Earnings growth over the long run tracks nominal GDP. That has risen about 6% over the past year. Companies will reach a point when they can no longer raise profits at a faster clip than revenue. It is possible that once earnings forecasts start coming down, fears of declining profits will spark a market correction.
Domestic and Global Politics: This is a difficult risk to assess, but deserves mention. The market has handled geopolitical risks with aplomb in recent years, but if the market is primed for a correction, an event could spark selling. Domestically, there could be a shift in perceptions from the value of gridlock to concerns about a revival of trade protectionism, as well as possible anti-profit oriented initiatives towards the oil and pharmaceutical sectors.
Bottom Line Fundamentals
A correction is often called healthy for a bull market. Yet, it is very hard to remember that while the price of every stock one holds is going down, and there are analysts proclaiming the start of a new bear market.
Yet, if the fundamentals do not significantly change, a correction would indeed provide a buying opportunity.
It is important to remember that the fundamentals remain bullish, and are likely to remain so, for the following reasons:
1) Valuations are very reasonable. The S&P 500 trades at just 16.3 times trailing operating earnings. That is a 6.1% earnings yield that compares very favorably to bond yields.
2) Economic growth will continue despite possible dire statements about consumer spending and the housing market. Real incomes are rising due to strong employment growth, a pick-up in wage growth, and low inflation. Business investment trends are strong. A few bad days of consumer spending or reports that the day after Thanksgiving was not great for Wal-Mart does not mean a recession is imminent.
3) Earnings growth, even if it drops to 5%, will provide fuel for further stock gains. If the P/E holds steady, 5% earnings growth will lead to a 5% gain in the stock market. The shift in view from 10% growth to 5% could, however, produce initial disappointment.
What It All Means
A correction over the next several months is very possible. It could well come in the first quarter after the traditional year-end market strength. Or, it could come earlier if the market anticipates such concerns.
A correction could be sparked by a limited amount of data on a key fundamental that is in fact insufficient to alter the underlying trend but nevertheless brings latent fears to the surface. Extrapolating dire consequences from a very limited amount of data points is a time-honored market tradition. It can happen at any time.
Yet, keeping a cool head during a correction will present buying opportunities. That is easy advice to write, but not so easy to follow. In July, when market sentiment was very poor, our view was turning more bullish. Yet, we did not move our Market View back to moderately bullish until August in part because it was so hard to fight the prevailing sentiment.
The market can't go straight up forever. A correction is very possible over the near term. Yet, the underlying trends in the economy, earnings, and interest rates remain distinctly bullish. Unless there is a significant alteration in any of these, a correction would prove exactly what it is defined to mean - a temporary market set-back.
The market is indeed due for a correction, but until the fundamentals change this is still a bull market.
