Thursday, May 22, 2014

Anatomy of an Internal Correction (excerpt)

Investors experienced a few hair-raising stock market corrections during the current bull market. From 2010 through 2012, there were five significant ones. The first one was during the spring of 2010 when the S&P dropped 16.0%. The worst hair-raiser was during the summer of 2012 when the S&P 500 plunged 19.4%, near the 20% drop that marks a bear market. That was followed during the fall of that year by a 9.8% decline, just short of the 10% that marks an “official” correction. There was another borderline correction of 9.9% during the summer of 2012, which was followed by a mini-correction of 7.7% during the fall.

The five corrections lasted from 27-154 days. Subsequent selloffs have been shorter and shallower, hardly meriting being called "corrections." All of these five corrections were triggered by macroeconomic events that threatened to precipitate a recession. When those threats dissipated, the bull market resumed. The anxiety attacks that caused the corrections were followed by relief rallies.

This year’s correction is unique so far. The S&P 500 is down just 0.5% from its record high on May 13. However, lots of stocks are down 10%-20% since March. They tend to be SmallCaps, as evidenced by the 8.7% decline in the Russell 2000, and the 12.2% drop in its Growth component. The Nasdaq is down 5.2% from its recent high. However, some LargeCap stocks have also taken big hits. In the S&P 500, Biotechnology, Internet Software & Services, and Consumer Discretionary Retail are down 13.5%, 12.0%, and 9.4% from their recent peaks.

I have characterized the recent selloff as an “internal correction.” Scrambling to avoid giving back the fabulous gains from last year’s melt-up rally, institutional investors have been rebalancing their portfolios away from high-P/E to low-P/E stocks. They’ve moved some of their portfolios out of Growth into Value stocks. Stocks with predictable earnings are outperforming the more cyclical ones. Among the losers have been lots of “innocent bystanders” that have been pummeled mostly because they are included in out-of-favor ETFs.

Today's Morning Briefing: Exit & Entry Strategies. (1) Hair-raising corrections. (2) Internal vs. external corrections. (3) Innocent bystanders. (4) Will Congress invert corporate inversions? (5) Too many bulls again. (6) Central banks: coming or going? (7) ECB set to do more of whatever it takes next month. (8) Janet Yellen and John Wayne. (9) New Fedspeak word: "Normalization." (10) Dudley is ready to raise rates eventually, but not by much. (11) Surprisingly weak earnings in UK and Eurozone. (12) Not all sectors in Japan getting a lift from Abenomics. (More for subscribers.)

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