February 3, 2014
by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Key Points
- For now, the EM tail is wagging the dog, but the US remains the world's big dog and should ultimately get through the latest turmoil.
- "January Barometer" has sent mixed signals for the remainder of the year historically.
- More technical and sentiment recovery is likely needed before a market recovery is likely.
The United States has always been the big dog … the one that typically wags the tail. So far this year though, emerging markets (EMs) are the tail that is wagging the dog. The obvious question is how much longer … the answer is less obvious.
As most readers know we've been alerting investors of the likelihood of a correction since late last year; largely due to the frothy sentiment conditions that (naturally) accompanied a stellar year in 2013 and the beginning of monetary policy normalization via the Federal Reserve's tapering of quantitative easing (QE). We have also noted that the next "crisis" was more likely to occur in EM than in the United States. For our take on what's been happening in EM, please see Michelle Gibley's latest report on the topic. As for whether EM turmoil will knock the US market fully off its rails, read on.
As January goes, so goes the year?
Let's start with the so-called January Barometer. Since the inception of the S&P 500 in 1928, there have been 31 down Januarys, with an average decline of 3.9%. About 58% of the time, the market went on to post a negative year, with an average decline of 13.8%. Narrowing the analysis down to the post-WWII era; since 1950, there have been 24 down Januarys, with an average decline of 3.9%. About 54% of the time, the market went on to post a negative year, with an average decline of 14.9%.
Of course, there were exceptions. For the negative Januarys that were associated with up years, the average gains were 13.6% since 1928 and 8.9% since 1950. In fact, the most recent occurrence of a negative January was 2009; during which the S&P posted a 23.5% gain for the full year. (Thanks to Ed Yardeni for this data.)
Technical damage … more likely to come
A lot of attention has also been devoted to the breach by the S&P 500 of its 50-day moving average (DMA) on January 24. It had been three months since it last closed below that level. The potential good news is that more often than not, the break below has not been indicative of more serious correction.
S&P 500's Breach
Source: FactSet, as of January 31, 2014.
According to Bespoke Investment Group, in the S&P 500's history there have been 62 occurrences of the index closing below its 50 DMA after trading above it for the prior three months or more. The average returns over the subsequent week, month and three month periods are pretty strong: 0.48%, 1.66%, and 3.21%, respectively.
Looking at the more recent past 30 years, there have been 23 instances when the 50 DMA was crossed after at least three months of closes above it. The average gains for the subsequent one week, one month and three months are 1.03%, 2.95% and 3.97%, respectively. Over this period, the market was up 65%, 74% and 83% of the time, respectively. Excluding the extreme outlier of 1987, the only three down periods over the following three month period in the past 30 years averaged a decline of only 0.76%.
Although I don't profess to wear a technician's hat very well, it does feel like we're at a greater risk this time of breaking down further and possibly testing (or breaking through) the S&P 500's 200 DMA. That would take the decline to over 7% from its peak. If the market doesn't hold there, that would likely set the stage for a legitimate correction (defined as a drop of at least 10%).
Sentiment recovery … more likely needed
In the meantime, important to watch are sentiment conditions; which so far, have not corrected sufficiently to suggest a near-term bottom can easily be found. As you can see in the chart below, more "work" needs to be done to bring sentiment back down into the extreme pessimism zone; which has historically led to better short-term gains for the market.
Sentiment Not Pessimistic Enough
Source: FactSet, Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2014(c) Ned Davis Research, Inc. All rights reserved.), as of January 28, 2014.
I also watch a sentiment indicator put out by SentimenTrader.com (ST) which measures what the "smart money" is doing relative to the "dumb money" (their labels, not mine). You can see the latest readings below; and it's clear there's more work needed here to set the stage for a meaningful rebound. The Smart Money getting a reading above 60 and the Dumb Money getting to a reading below 40 would be a healthy short-term signal.
More "Smart Money" Confidence Needed
Source: FactSet, www.sentimentrader.com, as of January 31, 2014.
I often get asked about this sentiment indicator … and often criticized by those who think the labels are mine. The Smart Money Confidence and Dumb Money Confidence indices show, in one quick glance, what the "good" market timers are doing with their money compared to what the "bad" market timers are doing. ST's confidence indices use mostly real-money gauges—there are few opinions involved.
Generally, you want to follow the Smart Money traders when they reach an extreme—to bet on a market rally when they are confident of rising prices; and you want to be much more defensive when they are expecting a market decline. Examples of some Smart Money indicators include the OEX put/call and open interest ratios, commercial hedger positions in the equity index futures, and the current relationship between stocks and bonds.
In contrast to the Smart Money, you want to do the opposite of what the Dumb Money is doing when they are at an extreme. These traders have proven themselves over history to be bad at market timing. They get very bullish after a market rally and bearish after a market fall. By the time the majority of them catch on to a trend, it's often too late—the trend is about to reverse. Examples of some Dumb Money indicators include the equity-only put/call ratio, the flow into and out of the Rydex series of index mutual funds, and small speculators in equity index futures contracts.
EM contagion
In my travels over the past week, the topic of EM contagion into our market/economy has been front-and-center. As mentioned already, although I think the stock market's pullback could eventually become an actual correction, I also believe the secular bull market that began nearly five years ago is not dead … just taking a breather. There are financial market and economic connections between the developing and developed markets, but short-term EM currency crises are unlikely to have a lasting impact on our market.
First we can look at history. My friend Brian Belski at BMO Capital Markets recently did a study relating US stocks to EM stocks. He examined the performance of all rolling one-year periods for the S&P 500 (SPX) and the MSCI Emerging Market Index (MCEF) since 1987 (when data first became available), and isolated periods when MXEF performance was negative. The average return for the MXEF was -18.7% compared with 0.5% for the SPX during those periods. Admittedly, investors don't generally cheer flat returns; but relative to the near-bear market returns of EM during those periods, flat performance is laudable.
EM currency and stock market turmoil first erupted last summer when the Federal Reserve first began hinting about tapering QE. The latest eruption surrounds the Fed's start of tapering. The turmoil is characterized by an unwinding of "carry trades," with investors having borrowed in low-rate dollars to purchase higher-yielding securities elsewhere (often among EMs). Many of these trades are in the process of being unwound and contagion can take over as selling begets more selling (thanks to forces like margin calls).
Eventual positives for US market/economy
Shorter term, economic readings have been mixed however. There were 21 economic reports last week; with nine stronger than expected, nine weaker than expected and three in line with forecasts. And this week is a biggie, with both ISM readings (manufacturing and services) and Friday's jobs report. As of this writing, we already have the ISM manufacturing report, which was quite a bit weaker than expected, although still in expansion mode. My personal view is that many of the recent weaker economic readings are more weather-related than they are EM-related.
There are (eventual) positives that will accrue to the US economy and market; not least being a stronger dollar and lower commodity prices. Both are beneficial to a consumption-oriented economy like the United States'. The contagion of EM weakness to the US economy is likely more through financial markets channels than the economics of trade. US exports to the top five nations within the MXEF (China, South Korea, Taiwan, Brazil and South Africa) represent only 2% of US gross domestic product (GDP). About 30% of S&P 500 sales are international and Barclays estimates that about 10% come from EM.
Testament to global market weakness is the breakdown of performance among the US market's capitalization segments. The S&P 100 Index, which incorporates the mega-cap stocks, is down 4.1% year-to-date; worse than the S&P 500. The Russell 2000, the index for small caps, is down a lesser 2.8%; while the Russell Micro-Cap index is barely down, at -0.6%.
In addition, cyclical sectors have been underperforming more defensive sectors, while value is underperforming growth. These are signs of a deteriorating economic growth outlook and possible continued market weakness. We still think the US economy and stock market ultimately get through this, but for now rough sledding is likely to continue.
Barclay's has pointed out that the response by US equities to inflection points in monetary policy over the past 30 years have been quite homogeneous; even with different approached to policy. Equity market pullbacks were tightly dispersed between 7.5% and 9% over two-to-three months, followed by a recovery and a couple of quarters of range-bound trading before the uptrend resumed. This seems like a good roadmap to consider for the next few months.
