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Stock market correction coming?

Stock market correction coming?
August 24
15:41 2017

The stock market is going through its own version of that old phrase “life is what happens to you while you are making plans.” Gradually, individual stocks and sectors are peeling back from formerly rising trends, creating an environment that is well-known to us value-oriented, active investors, but likely being ignored by index fund investors.

As a value-oriented investor, I am finding an increasing number of stocks that are well off their highs of the past year. That is where I start to get interested along with my research team. Now, a falling stock can fall further, even much further, but my main goal of this exercise was to see if underneath the “stock market” lies an increasingly ill group of stocks. Corrections and bear markets often take out one group of stocks first, and by the time the leaders get crunched later on, the first to fall are the first to bottom and start to recover.

Adobe Stock

I segmented the S&P 500 (which is actually 505 stocks these days) into segments according to how much each stock was below its high point of the last 52 weeks. This allows us to see how much of “the market” is already in correction mode or worse. I did this as of the close of business on August 17, 2017. What I found was that the correction is indeed upon us, but investors in S&P 500 Index funds just have not felt it yet. If history is a guide (and it typically is), the stocks suffering now are less an anomaly and more of a “canary in a coal mine,” signally what the broader market will experience before too long.

YCharts 2017

As you can see, 220 of the 505 stocks were already down 10% from their 52-week highs. That’s 44% of the entire S&P 500! Furthermore, about 2/3 of those (150 of the stocks in the index, or 30% of the total index components) of that group were actually down at least 15%. And nearly 1 in 5 S&P 500 stocks were already down 20% or more from their highs of the past 12 months. Finally, nearly 1 in 10 stocks have fallen 30% from their peaks.

Meanwhile, investment pundits are doing their usual thing. They talk about how strong corporate earnings are, how interest rates are low, how consumers are excited spending their money, and that geopolitical events are blips on the radar screen of history. That’s what pundits always do. And they do so because they are in an industry that benefits them most when the stock market is advancing. They “wave the flag” of the eternal bull market. The talk these days is that we are “overdue for a correction” which is typically defined as a decline of 10% or more in the index they are discussing (usually the S&P 500). As Kramer of Seinfeld TV Series fame once said of his pending move from New York City to Los Angeles, “in my mind, I’m already there. But investors don’t have to imagine a correction. Its here, just not in the way that makes mainstream headlines.

As a long-short (“hedged”) investor, I am wary of such consistently rosy outlooks and more focused on what is happening beneath the market’s surface. Not to be a curmudgeon, but nine years into a bull market for the Nasdaq and S&P 500, we are due for more than a correction. We are due for a catastrophe. But as is often the case, market declines start with one group of stocks, and then it spreads like a virus. Someone needs to be the first to give way, and it is typically the “secondary” stocks that fade first. That’s the label market watchers used to use to refer to stocks not in the Dow Jones Industrial Average. Today I think the definition can apply to the market that exists beyond the 200 or so largest companies. The fact that the Russell 2000 small cap index was hovering at around the flat line year to date as of mid-August, while the S&P 500 and Dow both had healthy gains for the year, is one of many clues that something is amiss in the current U.S. stock market.

Comments provided are informational only, not individual investment advice or recommendations. Sungarden provides Advisory Services through Dynamic Wealth Advisors.

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