Correction or Bear Market?

We have always been firm believers that the stock market is a function of intrinsic value plus investor sentiment. According to our analysis the U.S. stock market appears overvalued on a fundamental basis, but using fundamental analysis as the sole source in determining shorter-term market behavior has not been a successful strategy in our opinion. If the efficient market hypothesis held true, then this wouldn’t be the case. The insertion of human behavior can keep a market fundamentally over or under-valued for quite some time. Determining near-term trends are important for portfolio management in that it assists in putting in place hedging and portfolio protection strategies to protect invested assets when the stock market gets choppy and volatile.   

Investor sentiment is a difficult thing to track and interpret. Investors tend to be a fickle bunch that will move in a herd-like fashion. When we have a “market correction” defined as a greater than 10% retreat from the market peak without a corresponding economic recession, that represents a behavioral move as opposed to a more significant “bear market”, a move of +20% retreat from the peak. A bear market is more a function of fundamental variables such as earnings deterioration and economic recessions. Unfortunately the stock market is the ultimate leading indicator and we as investors cannot distinguish between a correction or a bear market until after the fact. The best we can do is analyze the data presented to us, devise the most probable investment thesis and implement the appropriate investment actions, knowing that the investment thesis needs to be fluid and easily moldable to suit changes in the market data.

When going through my weekend readings, I came across several sentiment indicators that make the case that the bottom has been set. 

The sentiment case for the bottom.

On the blog site The Short Side of Long, the authors pointed to the Investor Intelligence Bullish survey. They write, “Investor Intelligence Survey has been around for many decades and it aims to track the mood and opinion of financial advisors and newsletter editors. Readings reported yesterday show that bullish advisors have now fallen below 30% for the first time since March 2009. Furthermore, this reading is two and half standard deviations below the mean. Historically, it is very rare to see bullish percentage fall below 30% in this indicator. If the [sic] closely observe the chart above, ver [sic] the last two decades bullish readings below 30% were seen during the October 2002, November 2008 and March 2009.”  

Additionally, Bank of America Merrill Lynch's proprietary Sell Side Consensus Indicator shows extreme negative sentiment that is usually present near market troughs. This indicator was highlighted in Business Insider where they opine, “One of the more popular metrics used by contrarians is Bank of America Merrill Lynch's proprietary "Sell Side Consensus Indicator," which measures bullishness and bearishness among professionals based on how they're recommending clients allocate stocks in their portfolios. When many of them recommend avoiding or staying underweight stocks, this is a reflection of bearishness. And, as a contrarian indicator, this is interpreted as a signal to buy.”

The confusing part of the analysis from BAML is that they recognize the sentiment levels as a contratian “buy” signal and expect the market to return +17% over the coming twelve months but are currently recommending to clients to significantly underweight stocks at 54% of the portfolio compared to a traditional long-term average of 60 – 65%.

In the same article they go on to quote Citi’s Tobias Levkovich and his “Panic/Euphoric Model” I have been a tremendous fan and follower of Mr. Levkovich and think his work is brilliant, so when he provides insight I tend to listen. The article states, “Citi's Tobias Levkovich was on Bloomberg TV Monday afternoon discussing Citi's proprietary "Panic/Euphoria Model," which is a model that factors in nine metrics like the NYSE short-interest ratio, margin debt, Nasdaq daily volume as % of NYSE volume, the put/call ratio, AAII bullishness data, and others. "Statistically, you’re talking about a 96% probability that markets are up 12 months later," Levkovich told Bloomberg's Alix Steel and Scarlett Fu. In a note to clients in August, he wrote that this level of panic has seen an average 12-month return is 17.5%.”

Similarly, “Barclays' Ian Scott also circulated a note to clients noting the collapse in sentiment as measured by the Investors' Intelligence survey.” Sentiment towards stocks is now firmly below average, with just 9% more bulls than bears," Scott wrote. "While we would be the first to acknowledge that sentiment does not have a “call” on the market before 2009, in the post Financial Crisis environment, it certainly has. Indeed, whenever the percentage of bulls has dropped below 9.5% the market has consistently been higher 6 months later, with an average gain of 22%."”

Another sentiment indicator we track is the AAII Investor Sentiment Survey. The latest reading shows of those participants surveyed, 32.4% are bullish on the market while 31.7% are bearish. I like to take a ratio of “bulls/bears” and come up with a current reading of 1.02. Typically a reading of 0.60 for lower is a sign of extreme bearishness and could be considered a buy signal. This ratio is considered to be quite low currently and indicative of a contrarian buy signal. The caveat here is that this ratio has been giving overly pessimistic readings from the start of the year so the contrarian quality of this model has not been all that accurate lately.

The latest Gallup Poll on economic confidence continues its descent. The latest reading indicates the following: “Americans' confidence in the economy continued to fall last week. Gallup's U.S. Economic Confidence Index slid three points to -17 after also declining three points the prior week. This is the lowest the index has been since September 2014, and comes as international markets struggle amid volatility in China's stock market.”

They conclude, “The plunge in China's stock market has caused repercussions far beyond Asia, sending financial markets worldwide into tailspins last week. In the U.S., combined losses of over 1,000 points in the Dow Jones industrial average have pushed Americans' economic confidence further into negative territory. Late last week, U.S. markets appeared to stabilize somewhat -- in part because of positive indicators of the strength of the domestic economy, including a much better than initially reported GDP growth rate for the second quarter. While the Dow still struggles amid uncertainty in Asia, Americans' economic confidence seems to be recovering.”

A post by Business Insider shows that global asset correlations are increasing indicating investors are selling across the board (graphic provided by Morgan Stanley). When asset correlations reach such extremes it usually indicates a near-term bottom according to analysis done by Citi.

The concept makes sense to me but when viewing the graphic provided, I don’t see any relevance especially in 2003 and 2009 that marked major market bottoms. I do think correlation is important in that negative investor sentiment spilling over from China can drive our markets lower (more on this later).

If there truly is blood in the streets and investors are running for the exits then one wouldn’t know it from the data released by BAML client cash flow data. In their latest release (via Business Insider): “According to Bank of America Merrill Lynch, the firm's equity clients moved money into stocks at the fastest pace since at least 2008 during a week that saw markets crater to start the week but ultimately finish in the green.”

“The firm's clients were net buyers of $5.6 billion of US stocks from August 24 to August 28. Though BAML noted that no single client group — which covers hedge funds, institutional investors, private investors, and corporations — saw a record flow relative to its own history.”

We believe that extreme negative investor sentiment is a precursor of market bottoms and the cash flow actions exhibited by BAML clients run counter to that. Perhaps there is a sense of security that the Fed will come in and launch measures to sustain equity prices. We have had several years to become accustomed to the “Fed put” providing a floor during market turmoil. Should the Fed not come to the rescue this time around things could take a turn for the worse and investor sentiment, along with the stock market may suffer.

In a note from Deutsche Bank (via Business Insider), “The note recaps the landmark moves of last week: a so-called seven-sigma move in equities, an all-time record change in the volatility of volatility, a 700-point change in the S&P 5oo over the week, and four consecutive days of six-sigma moves in oil. All in all, according to the note, "recent trading sessions were nothing short of extraordinary." The strategists took a look at similar historical periods to try and get a read on how markets typically react in the aftermath of such historic events. The Vix, which uses option prices to gauge expectations of volatility, closed above 30 three days in a row early last week, and did the same Tuesday. It is currently trading at around 26.”

“History seems to suggest that once volatility jumps to 30, it will stay there for several weeks, and in some cases months. That has been the case on seven different periods in the past, according to the note.

It said: The only exceptions that happened during the past 20 years have taken place in early 2000 and late 2007/early 2008. So technically speaking, even periods of quick reversal from a 30pt VIX levels have previously proven to be prescient indicators of more volatility to come down the road. We would thus caution our readers not to be too quick in dismissing what happened over the past two weeks as simple "overreaction".”

The September Effect

According to Money on-line, “Sam Stovall, U.S. equity strategist for S&P Capital IQ, points out that despite the market’s tremendous rebound last week, the S&P 500 index of blue chip U.S. stocks is still down 5.5% month to date. Why is that significant? “In the 11 times that the S&P 500 fell by more than 5% in August, it declined in 80% of the subsequent Septembers, and fell an average of nearly 4%,” Stovall says. Plus there’s the fact that the Septembers, like August, are one of the spookiest months for stocks. Over the past quarter century, August has been the worst month for the Dow and S&P 500. Yet over the past half century, September actually holds that title, according to the Stock Trader’s Almanac.”

We expect to see continued weakness in the market. While sentiment indicators appear to be bottoming and may provide a bounce higher from here, we will continue our cautionary stance until we can get further clarity on whether this is a correction that is winding down or the start of a bear market. With intermediate and longer-term momentum falling, we will use any short-term overbought situations to increase our portfolio protection or take a directional stance for our more opportunistic clients.

China

Continued weakness in China may increase negative investor sentiment in the U.S. markets. A survey done on the blog site Vix and More states the following: “In the chart below, I have summarized the top ten responses from almost 400 voters, covering 40 countries over the past two days.  The question:  “Which of the following makes you most fearful anxious or uncertain about the stock market?””

Weakened economic growth in China comes out on top. Indeed the economic data coming from China and the rest of the world (ex-U.S.) seems to be deteriorating.  Last week saw the official manufacturing PMI for China fall to 49.7 in August. This is the lowest reading since August 2012 and signifies manufacturing contraction in the country. The Caixin-Markit manufacturing slipped to 47.3, the steepest contraction since March 2009 and also suggests their manufacturing sector is shrinking. The decline in everything raw materials confirms this notion.

A sure tell-tale signal that China’s economy is slowing is the South Korean export figure for August. According to Business Insider, “South Korean exports in August plunged 14.7% from a year ago. This was much worse than the 5.9% decline expected by economists. And it was the biggest drop since August 2009. This is a troubling sign, as Korea's exports represent the world's imports. Because it is the first monthly set of hard economic numbers from a major economy, economists across Wall Street dub South Korean exports as the global economic "canary in the coal mine." Korea is a major producer of goods ranging from automobiles and petrochemicals to electronics such as PCs and mobile devices. "The country has long been a reliable bellwether," HSBC's Frederic Neumann told Reuters.”

“China, the world's second-largest economy, is Korea's biggest customer. And while many experts are skeptical of the reliability of China's official trade data, few doubt the quality of Korea's data. "In the last decade, China was a major growth driver for Korea," Morgan Stanley's Sharon Lam said on Tuesday. "Korean exporters are proud of their success in China, as witnessed by Korea overtaking Japan to become China's number one import source since 2013. Korea's success in the Chinese market was characterized by its brand name, technology, and marketing efforts. Unfortunately, China is no longer a positive factor for Korea and in fact it has become a negative drag."”

The International Monetary Fund has come out last week to reiterate their thoughts that the global economy is prone to slowing with the slowdown in China as a key culprit. Previously they called for the Fed to reconsider tightening monetary policy in the U.S. as the global outlook appears to be deteriorating. They cite the slowing Chinese economy, weakening commodity prices, strong U.S. dollar, emerging market struggles and market volatility as reasons for the Fed to stand down. Time will tell but the Fed appears to be on pace to raise rates sometime this year.

Just a glance at the global economic headlines last week paints a dour picture of current events.

·         US manufacturing is decelerating. The ISM manufacturing index fell to 51.1 in August from 52.7 in July. This was worse than the 52.5 forecast by economists, and it was the lowest reading since May 2013. 10 of 18 industries reported growth. From the ISM: "The New Orders Index registered 51.7 percent, a decrease of 4.8 percentage points from the reading of 56.5 percent in July. The Production Index registered 53.6 percent, 2.4 percentage points below the July reading of 56 percent. The Employment Index registered 51.2 percent, 1.5 percentage points below the July reading of 52.7 percent." – Business Insider

·         The eurozone manufacturing PMI slipped to 52.3 in August from 52.5 in July. Italy, Spain, Ireland, Netherlands, and Austria all experienced deterioration in growth. Meanwhile, France's PMI fell to a four-month low of 48.3, which reflects outright contraction. – Business Insider

·         Canada is in recession. GDP contracted at a 0.5% rate in Q2 following a 0.8% contraction in Q1. The back-to-back quarters of contraction mean that the economy is in recession. – Business Insider

·         Macau gaming revenue crashed. Gaming revenue in Macau crashed 35.5% in August, marking a 15th straight monthly decline, according to the FT. The pronounced slowdown comes after Beijing's crackdown on VIP gaming, but weakness can also be seen in the "mass" revenue data. On Monday, Macau announced second-quarter gross domestic product collapsed 26% compared with last year. – Business Insider

·         French Manufacturing continues to reel. France's Final Manufacturing PMI fell to 48.3 in August, from 48.6 in July. The number was shy of the 48.6 that economists were forecasting and makes for the worst reading in four months. Italy and Spain also saw slowdowns in manufacturing while Germany's reading climbed to 53.3, its best level since May 2014. The eurozone as a whole saw its reading slip to 52.3 from 52.4. The euro is stronger by 0.5% at 1.1267. – Business Insider

·         Reflective of weakness in China and the US, growth in global manufacturing activity decelerated sharply in August with the J.P. Morgan-Markit global manufacturing PMI gauge falling to 50.7. While activity has expanded for 33 consecutive months, the reading was the lowest seen since April 2013. – Business Insider

With the seemingly slowing economic profile, does that mean the U.S. will catch the contagion of the global slowdown? For us it’s way too early to know but Scott Grannis from Calafia Beach Pundit agrues against that scenario. He writes, “Markets are still on edge, worried that a China slowdown will prove contagious to the rest of the world—a new twist on the old catchphrase "When the US sneezes, the rest of the world catches a cold." But the mainstay of the U.S. economy—the service sector—is still quite healthy. The U.S. economy has been underperforming for years, but that has everything to do with our own bad policy choices. Even a substantial slowdown of the Chinese economy would have little impact on the U.S., since China's purchases of goods and services from us represent a mere 0.7% of our annual GDP.”

“As the chart above shows, the service sectors of both the U.S. and the Eurozone have been gradually improving over the past year or two (and the U.S. survey beat expectations, 59 vs. 58.2). This arguably trumps any slowdown in the growth of the Chinese economy.”

“The Business Activity subindex of the ISM service sector survey is still at historically high levels, and doing much better than at anytime during the current expansion. This represents about 80% of our GDP. This is great news.”

“The Employment portion of the ISM service sector survey is still at relatively healthy levels. This suggests that businesses are reasonably confident about their future prospects.”

Bottom Line: There is no way of determining if this is going to be a market correction in the bull market or the start of a new bear market. Thus far the evidence points to a correction thesis as we believe it would take a U.S. economic recession to materialize to initiate the bear market case. We expect continued market volatility with a near-term rally followed by market weakness into the end of 3Q and into 4Q before stabilizing and heading higher again. Intermediate and long-term momentum remains negative and we will be preparing to use overbought situations to protect and/or monetize further weakness. Should the global and U.S. economic picture continue to deteriorate, then we will readdress our thesis.

Joseph S. Kalinowski, CFA

Additional Reading

Stocks Are Sending a Recession Warning – The Fiscal Times

This Is Now The Worst Possible Environment For Stock Market Investors – The Felder Report

Rising Anxiety That Stocks Are Overpriced – Robert Shiller oped New York Times

IMF WARNS: China's slowdown is much worse for the world than we had thought – Business Insider

 

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