Friday, October 30, 2009

Is this the long awaited correction?

As the S&P 500 began to weaken last week, there has been a cacophony of voices declaring that this is THE CORRECTION. The questions in a lot of investors’ minds are:
  • Are we starting a major correction?
  • If so, how far down are we going?

Personally, I believe that the market’s fundamentals were too overstretched for this to be a minor pullback and I concur with the assessment that the bears are taking control of the tape. The tone of the instant euphoria over yesterday's one-day rally of 2% is a contrary bearish signal that this market has further downside in the weeks ahead.

How far down?
Downside targets for the S&P 500 vary wildly. Among technicians, the 920-950 level is often cited as a target, a 10-15% correction. That target level would roughly be the 200-day moving average should the market decline to those levels in the next two or three months.

More bearish types like David Waggoner at Minyanville has suggested that a multi-year top could be in and the “next intermediate level pivot down is around 882”.

Fundamentally oriented investors appear to be more bearish than technicians. Jeremy Grantham’s latest quarterly letter stated that GMO’s fair value on the S&P 500 is 860. Grantham believes that a correction, when it comes, would be at least 15% and would likely overshoot their fair value estimate – which makes downside risk considerable from current levels. David Rosenberg believes that the market is 20% overvalued. By contrast, the market appears even more overvalued if we were to use Tobin Q as a valuation standard.

What to watch for
Trying to guess the downside target here is a mug’s game. I have no idea whether this is a minor pullback or a major correction that could see us test the 666 old lows. I believe that the bears are in control, but here is what I am watching for to see how far the market could decline.

  • What is the appetite for risk? Don’t forget that the market’s rally from the March lows has been a risk trade all the way up. It’s hasn’t been just stocks that have been rising, but all risky assets. I would therefore watch all risk measures, such as quality spreads in the bond market. More importantly, I would watch the US Dollar. Art Cashin recently suggested that the USD has been the funding currency for currency carry trades and a big reversal in the greenback could cause over-leveraged hedge funds and trading desks to de-risk in a hurry. If reversals in the Dollar are subdued, then corrective action in the stock market could be subdued as well.
  • What about sentiment? In my post A fragile and frothy market I pointed out that institutions and hedge funds were in a crowded long, but individual investors had been skeptical of the market rally. Watching indicators like the AAII sentiment surveys would be an important sign in the weeks ahead of whether individuals buy on weakness, which would be bullish short term but bearish medium term, or stay cautious, which may portend a more limited correction. If individual investors are convinced that the economy is truly turning around (and never mind the snark) and buy, then it could truly be a sign that we may have seen a multi-year top for the S&P 500.


Patrick said...

What do you make of the Elliot Wave model that suggests the entire move from 666 was one big correction of the fall from 2007 highs and that we´re actually entering an even more dramatic push to new lows?

Cam Hui, CFA said...


I have never had much success with Elliot Wave models so I can't really comment. The trouble with Elliot Wave is that the model is extremely initial condition sensitive. Depending on how you anchor the start of your wave, you could come to two completely different conclusions.

Patrick said...

I don´t rely on Ewave for anything but top level confirmation and a clue of where the good risk/reward set-ups might be, I still look at volume, fractals, momentum and so forth to confirm.

Lets abstract Elliot out of the equation for a minute. Considering market breadth divergence and momentum divergences, and of course fundamentals if you prefer, how likely do you think it is that the prevailing direction of the SPX is still down?