Market Undergoes Much-Needed Correction Off of Overbought Condition

The headline in last week’s column said that the “market reaches new all-time highs, perhaps needing some sort of rest.” And this is exactly what has transpired in the past several days, as after the Dow Jones Industrials, S&P, Russell 2000 Index of small stocks, the various mid-cap indexes and the Dow Jones Transports all attained best-ever levels on August 2, things have cooled off a bit as the “Market Maven” indicated they most likely would.

This has not been an unexpected development, as there were a number of indications that the market had gotten ahead of itself. As examples of how overbought stocks had gotten, it was pointed out that 83 percent of S&P stocks were trading above their 50-day moving averages and this compared to only 13 percent that were above this benchmark after the 5.8 percent Fed-induced downward correction from what were then the May 21 all-time highs to the June 24 lows. In addition, 115 S&P stocks had a relative strength reading over 70, the highest since May 21 as well, which meant that “some sort of selloff might be in the works.” Furthermore, the volatility index, known as the VIX, had fallen to the 11 level, which historically has indicated a very high level of complacency among investors, which invariably leads to some sort of downward movement.

And sure enough, last week saw both the S&P and Nasdaq undergo their worst weekly showings since the week ended June 21 and the Dow finally ended its six-week winning streak, which was its longest in a year. There were now some ETF equity withdrawals to the tune of $1.2 billion after $32 billion was put into these vehicles last month, the largest such participation rate since September 2008.

So what fundamentally happened to cause things to cool off, aside from the fact that technically the market was in need of some sort of pullback? The first reason was that statements from the presidents of various Fed regional banks in Atlanta, Chicago, Cleveland and Dallas all alluded in one way or the other to the fact that the central bank is strongly considering some sort of tapering next month of the $85 billion-a-month stimulus program. To some investors this is sort of anathema, because the various Fed stimulus programs over the past four years have been largely credited with helping the market achieve a historic 150 percent gain from the March 2009 lows. Therefore, if part of the stimulus is taken away, the economic fundamentals of the U.S. economy might not be strong enough to justify equity prices at current levels. On the other hand, it would appear that the Federal Reserve would not undergo any sort of tapering program if it was not convinced that indeed the labor market has improved to the point where it can contribute to carrying the economy to ongoing improvement. Of course this is a very debatable subject, and the wisest course is to see how the various scenarios play themselves out over the next several weeks.

And the reason it is debatable is that the recent statements from these top Fed officials appear to be at odds with the statement released at the conclusion of the last F.O.M.C. meeting in July. The statement actually leaned toward the dovish side, with the implication that tapering was not yet in sight, as it slightly downgraded its view of the recovery, calling the pace of growth “modest” rather than “moderate” as it had consistently done for most of the past year. It also noted that mortgage rates had risen, which implied that this is a potential headwind to the housing recovery. Finally, it paid lip service to the potential dangers of inflation being too low, which meant that the full stimulus programs have not led to inflationary pressures and a subsequent weakening of the dollar as many had feared.

In addition to the worries about potential tapering of the stimulus programs, there are concerns about the German parliamentary elections that will take place on September 22, four days after the next Fed meeting on September 18. There is no guarantee that Chancellor Merkel’s party can hold onto its current majority, and if this is the case then the person who has been called the de facto leader of the EU could lose her political clout. Then there is a word that has been somewhat forgotten over the last several months that is now making a return engagement, and it is none other than “sequester,” which brings with it the potential for further federal budget cuts along with the always-contentious political issue of raising the debt ceiling. Finally, there are reports that back-to-school sales are going poorly.

All of these concerns certainly give investors plenty to worry about as the dog days of summer drag on with very light volume on both up and down days this month.

Second-quarter earnings are mercifully coming to a close, as 450 of the 500 S&P companies have now reported, with a profit gain of 4 percent, while revenues have only increased by a paltry one percent or so. Seventy percent of companies have beaten their earnings estimates while 55 percent have beaten on the revenue side, better than the 48 percent average of the past four quarters but less than the 61 percent beat rate since 2002.

A recent bright spot has been better economic news from China, as firm rebounds in both their exports and imports last month offered some hope that the world’s second largest economy might be stabilizing after more than two years of slowing growth. On the other hand, an imminent rebound appears unlikely at the present time, as the government there is trying to contain growth at a floor of 7.5 percent after a decade of double-digit advances. This is vital to reforming their economy so as to get it more driven by consumption rather than debt-funded investment and manufacturing. It is important to both their economy and ours and it was encouraging that exports to the U.S. rose at an annual 5.3 percent rate while imports of oil, agricultural products and metals such as copper and iron ore rose substantially. This is the major reason why U.S. stocks that represent the minerals, mining and resource sectors have done well lately as the overall market has sagged a bit.


Donald Selkin is the Chief Market Strategist at National Securities in New York, a veteran in the securities industry for 36 years who is widely quoted in the financial media. 

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