"But the fundamentals are great!"
We hear this all the time; almost as many times as we hear "but we're off the lows for the session" on CNBC almost every day since the highs a month ago. It's not always about how great the lagging or coincident indicators are, especially when the leading indicators have peaked and are rolling over. As I have said time and again, to some testy retorts I must add, overvalued markets are more vulnerable than undervalued markets. Simply put.
Now, think back. Real GDP posted an 8-per-cent gain in the second quarter of 2000 just as the Nasdaq was rolling off the lofty highs it would never climb again - not to mention the huge 300,000 in job gains at the time. By the first quarter of 2001, GDP was falling at a 1.3-per-cent annual rate. Who was calling for that a year before when the fundamentals were viewed as being so solid by the economic elite of the time?
What about 1998? In the same quarter that the S&P 500 cratered 20 per cent amid the fallout of the Asian crisis, real GDP in the U.S. was up at a ripping 5.4 per cent annual rate and non-farm payrolls were rising 250,000 per month to perpetuity, or so it seemed.
Then we have the mother of all corrections: October, 1987. In the same quarter as the collapse, we had real GDP up at a resounding 7-per-cent annual rate and employment, as in 2000, rising 300,000 per month.
The message: Trade and invest carefully in an overvalued market, which is what each of these periods had in common.
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As for the current situation, the fundamentals are actually less solid than many on Wall Street are letting on. It will be interesting to see what the fallout is on spending and confidence from this latest market downdraft and intense volatility.
I would submit that the only reason everyone was of the belief that the economy had made the full shift from recession to recovery was because the 80-per-cent surge in equity prices told them that this was the case.
The downdraft in the market in recent weeks reflects the financial risk related to the European debt crisis, the monetary tightening in China and the re-regulation of the financial sector. The next leg down in the equity market specifically and cyclical assets more generally is economic risk.
Equities went into this period of turbulence priced for peak earnings in 2011 and with a tailwind of positive earnings revision and positive guidance ratios from the corporate sector.
If the ECRI Institute and the Conference Board's own index of leading economic indicators in the U.S., which dipped 0.1 per cent in April, are prescient, then they are portending a period of sub-par economic growth ahead.
More-than-fully valued markets do not need a double-dip scenario to falter - a growth relapse can easily do the trick. It's still time to be defensive and too early in this correction to be picking the bottom.
The correction has left stocks looking neither cheap nor expensive, David Berman says
The equity market may well be technically oversold right now and due for a near-term bounce, but that would be a rally that would fade if we see it. There has been too much of a rupture to ignore, with the S&P 500, Dow and Nasdaq all closing below their 200-day moving averages.
History can be a useful tool so I went back as far as the 1870s to see how severe equity selloffs can be even during bull markets. While the 1987 correction was the most severe (down more than 30 per cent), we saw several instances where equities corrected by at least 10 per cent. In fact, only two of eight times did the correction stop at 10 per cent, with the average correction being 20 per cent.
There are two critical points to watch for now: the May 6 flash-crash intraday low of 1,065 on the S&P 500, and before that the 1,044.5 low on Feb. 5. If these don't hold, and the bulls need these levels to hold, then another leg down to or through the 970 or 950 level is likely. Beyond that, to turn bullish, we would need to see two big up-days in the stock market with large volume.
It would also help if market sentiment swung toward the bearish camp - the most recent Investors Intelligence survey has the bulls at 43.8 per cent and the bears at 24.7 per cent. At the lows, we would expect these numbers to be reversed.
David Rosenberg