Michael Santoli

Did the Promised Market Pullback Just Come, and Go?

Michael Santoli

Has the “overdue pullback” that a host of market watchers invited already arrived and left? Did the “healthy correction” that so many investors prescribed already deliver its unpleasant therapy over the course a week’s time and 3% ebb in the Standard & Poor’s 500 index?

While many try, it’s never possible to draw the next wiggle or wave on the stock chart, of course. What’s certain is that stocks’ gentle, imperturbable ascent to start the year faltered in the past week, as some loud noises scattered the sparrows and reintroduced volatility into the air.

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Stock market traders: Credit Reuters
The market’s rebound of around 250 Dow Jones Industrial Average points since midday Tuesday is probably best viewed as a respectable bounce and gesture of resilience, rather than a decisive sign the market’s resolute 12-week climb has resumed to take stocks powerfully higher from here.

The linear explanation tells us the tape last week was buffeted first by (mostly vaporous) fears of a less-generous Federal Reserve, and then Monday by the old ill winds of European financial unease kicking up, following Italy’s anti-austerity election outcome. The backdrop, though, is that investor sentiment had become rather complacent in the short term, the bullish story of easy money with nowhere to go, but stocks too widely taken for granted.

As Keith Lerner, market strategist at SunTrust Bank, noted after the Italian-accented selloff: “When investor expectations become elevated, a little bad news can go a long way.”

It’s telling how quickly anxiety levels and demand for protective stock options surged on a drop of a couple of percent, perhaps because things had been so calm for so long. It pays to remember that even widely anticipated, hoped-for pullbacks that can reset expectations and refresh buying interest always come along with scary prospects that they are the start of something nastier. Not all tremors are followed by earthquakes, but you never know in advance which ones will be.

For all the cheering of Wednesday’s rally, on a very short-term basis all the indexes have done is simply hustled back to the upper end of their recent range. The market has, for perfectly valid reasons, so far ignored the automatic government spending cuts about to hit. The first dip, as stock partisans predicted, was bought.

Outside of stocks, though, 10-year Treasury-note yields have remained subdued the past two days, refusing to climb back above 2% as they likely would if risk appetites and economic momentum were clearly back on the rise. That’s a yellow flashing light.

In a broad sense, the market continues to follow the first-quarter path trod in each of the past two years -- rising by 6% to 8% by Valentine’s Day, then losing some altitude into March. In the prior two years, stocks regained their footing and ticked to a new year-to-date high in April before undergoing a deeper retreat. The market doesn’t often track the same pattern three years running, but this one bears watching.

Lerner points out that since the bear-market low of March 2009, the S&P 500 has experienced a drop of at least 5% nine times. The median decline was 7.1%.

Beneath the surface, it appears the market needs to rebuild momentum and gather up more buying interest if the major indexes are to do anything more than simply tag their all-time highs (less than 1% higher for the Dow, 4% for the S&P 500). This can occur either by chopping around sideways for a while in mutually frustrating fashion or through a quick run to lower prices.

Fed Chairman Bernanke’s highly predictable public assurances that he remains committed to open-ended bond-buying with conjured money is probably not enough alone to keep things powering higher. Just as last week’s scare about a possible early curtailment of quantitative easing were a red herring, this week’s reiterations of Fed resolve are not themselves fresh, market-energizing information. The Fed’s easing efforts now are context, not catalyst.

Yet, through a wider lens, the market looks well-supported until further notice by several key factors. The credit markets are still remarkably firm. It is here that economic-downturn warnings and financial-storm alerts are first sounded. Corporate bonds may seem priced to deliver unimpressive returns from here, as Bill Gross of Pimco recently asserted. But so long as they remain in liquid-hot demand, stocks get a pass.

The SPDR Barclays High Yield Bond ETF (JNK) has wobbled a bit in recent weeks, but has since stabilized. Same with the Bloomberg U.S. Financial Conditions Index: Watch these indicators for signs of when risks of something more serious than a healthy correction are high.

The internal makeup and long-term field position of the equity market also lend it some strength, of the sort that can offset the burdens of maturity. This is an aging, but unusually battle-tested, bull market, in which few pockets of excessive valuation or speculative silliness have built up.

Seven of the S&P 500’s 10 industry sectors account for at least 10% of its market value and corporate profits, implying decent balance. The prior two times the S&P 500 broke above 1500 in 2007 and 2000, the index was beholden to a narrow group of overvalued stocks (tech/telecom in 2000, finance/housing in 2007).

As Bernie Schaeffer of Schaeffer’s Investment Research calculated a month ago as the S&P surmounted 1500, the index’s very long-term 160-month moving average value was at 1210. Upon hitting 1500 in 2007, that moving average was 1032 and in 2000 it was only 586. That is to say, in those earlier times, the market was much farther above its long-term trend -- and arguably in thinner air -- than it is now.

None of that argues against the idea that the market has unfinished correction business to get through. But it shows that if this bull market is to feature one of those exciting, heedless, sky's-the-limit phases before it ends, we haven't gotten there yet.

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