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Investors search for signs of end to stock market correction

Measuring the point at which investors have exhausted their selling in a market downturn is an inexact science at best, and at its worst akin to sticking a finger in the air to judge shifting winds. By some measures, the near 10 percent decline in the Standard & Poor’s 500 stock index from a record high last month may already have flushed out much of the speculative money that helped propel a bull market in stocks beyond the average length.

Investors look for a number of signs to determine whether a correction has run its course. The reduction in big bets on the dollar and equities, the rebound of small-cap stocks, the rise in volatility and heavy activity in futures trading as the S&P plunged Wednesday all stand as potential signs that the selling is reaching a crescendo. For months, worries about European economy and the conflicts in the Middle East and between Russia and Ukraine didn’t shake the bullish conviction as the S&P 500 surged to a record closing high of 2,011.36 on September 18. But with the US Federal Reserve looking more serious about reducing stimulus and uncertainty surrounding the Ebola outbreak, the market finally succumbed to a bout of panic.

“One possibility is we’re seeing risk reduction not for economic or any kind of structural reasons, but maybe fear of Ebola,” said Jack Ablin, chief investment officer at BMO Private Bank in Chicago. “If that’s the case and things are transitory, headlines improve over time, perhaps we get back on track.”

According to Whitefish, Montana-based InvesTech, since 1932 there has been on average a 10 percent correction every 25.7 months. It has now been about three years since the last correction occurred in 2011. The S&P 500 has lost 7.4 percent since its September 18 high. “We are not surprised we are in a correction phase. … Typically, crisis events have a short-term impact and a month later the market starts to return to the position it was headed in prior to the downturn,” said Sandra Stoutenburg, senior market analyst at InvesTech Research.

One sign that stocks could be rebuilding a base is the turnaround in small-cap names. The recent outperformance of the Russell 2000, an index more closely associated with US-based companies, would suggest investors haven’t lost faith in the US economy, despite lousy overseas growth and concerns about weak inflation trends. After falling 12.9 percent from its March high, the Russell 2000 is up 3.1 percent this week, compared with a 2.3 percent decline in the S&P 500.

In addition, the high number of new 52-week lows seen in the broader market may indicate a turning point. The number of new 52-week lows on the NYSE hit 605 on Thursday, the most in three years, while just 21 issues hit new 52-week highs. That spread is comparable to the 600-to-21 difference seen on June 24, 2013, at the nadir of a 7.5 percent pullback in the S&P.

“You only get these levels of washed-out-ness at extremes,” said Bruce Zaro, chief technical strategist at Bolton Global Asset Management in Boston. The 14-day relative strength index on the S&P 500, a measure of internal momentum, was below the 30 level that indicates the index is oversold for a second session running on Thursday. The last time it closed under 30 for two straight days was on November 15, 2012, when the index bottomed after a near 8 percent slide.

The selloff has caused investors to start paying for protection against further declines. The CBOE Volatility index on Wednesday registered its highest closing level since June 2012. Notably, the VIX is still at a higher level than VIX futures contracts expiring between October and December, a sign that investors remain more worried about the next 30 days than the period after that.

Much of the fuel for the downturn has come from hedge funds cutting bait on popular long bets that are losing money. Long/short equity funds, which have the freedom to mix bets on stocks rising or falling, have been reducing their long bets in the last month, with net long exposure down to 41 percent from around 55 percent, according to Credit Suisse research.

While that shows hedge funds have sold out of losing positions, the ratio remains well above the 23 percent net long position the funds held when the market had a near 10 percent washout in June 2012. This could mean there’s another round of selling to come. “Hedge fund net exposures appear to be out of step with the October’s risk-off move,” Credit Suisse said in a note.

In contrast, the sharp rally in bonds, the slump in the price of oil and rise in cross-asset correlations more clearly signals risk-off panic hitting a peak. Jeffrey Kleintop, chief global investment strategist at Charles Schwab in Boston, said he is looking for signs of stability in commodities as a precursor to a recovery in equities. Commodities, he said, led the stock market, but “they really led the concern about deflation that now seems to be at the root of the concerns that are pushing stocks lower – this lingering and deepening weakness in the euro zone and the concern that it is spreading elsewhere.”

Crude oil prices have tumbled nearly 26 percent from a recent peak in June. Corn is off 32 percent since May and gold has lost 7.4 percent in the last four months. In other markets, big long positions in the dollar and bets on a sell-off in the bond market have been reversed. Coming into the week, the value of dollar long positions was $40.91 billion, the biggest since May 2013. As those positions are liquidated and volatility declines, selling across markets could abate.

Investors have maintained a steady level of buying stocks on margin, according to New York Stock Exchange data. August data, the latest available, showed borrowing of $463 billion, slightly more than the $460 billion in July and just off the record $465.7 billion set in February.

InvesTech’s Stoutenburg said a decisive drawdown in margin debt would suggest the market could be poised for a downturn. Overall, recent figures, including Thursday’s data on industrial production and jobless claims, still point to relatively solid US growth – suggesting investors need to be wary of extreme sentiment. “Margin debt ticked up in August, but if it turns down in a substantial way that is a real warning flag. History shows us that,” Stoutenburg said. “The economics in the US are firm. We are not seeing signs of recession here.”

Daniel Bases and Rodrigo Campos, "Investors search for signs of end to stock market correction," Business recorder. 2014-10-18.
Keywords: Economics , Economic issues , Economic policy , Economic system , Economic growth , Stock market , US economy , Stock exchange , Investment