When does the 'stealth correction' become the real thing?

Whenever the ascent of stock prices has faltered over the past couple of years, Pink’s lyrics have started playing across Wall Street: “We’re not broken, just bent.” Will this tune soon be playing again?

The second “stealth correction” of the year had been underway below the surface for a few weeks, with a broadening selection of B-list stocks tiring and investor risk appetites ebbing, and is now threatening to break into the open.

The task of playing for a more damaging break in the upward trend is complicated, though, by the fact that several such threats have proved empty in the recent past. And the sudden rush for safety amid shrill geopolitical news headlines Thursday is just the sort of hasty reflex action that has indicated decent Buy signals during this largely imperturbable bull run.

Yellen’s market call

One of the ironies of Federal Reserve Chair Janet Yellen’s singling out of small-cap, biotech and social media stocks as appearing overvalued is that these sectors have been under pressure for months.

These three market segments – as measured by exchange-traded funds tracking the iShares Russell 2000 (IWM), iShares Nasdaq Biotechnology (IBB) and Global X Social Media (SOCL) indexes – have lagged the blue-chip Standard & Poor’s 500 by between five and 15 percentage points in the past four months. Yellen was mostly voicing the conventional wisdom circa March 31 in commenting on isolated evidence of excessive investor confidence. As Yellen's remarks were scrutinized, these pockets of the market saw selloffs.

Sliced up differently, the largest 500 stocks in the market as tracked by Russell were up more than 8% in 2014 before Thursday, and the smallest 500 down an average of 6% - a huge performance spread that shows a marked preference this year for stable, global companies over fast-moving, speculative ones. From July 1 through Wednesday, too, the largest 500 names were about flat even as the littlest 500 slid more than 5%, according to Pension Partners.

Before the S&P 500 on Thursday dropped 1.14%, breaking a 62-day streak without at least a 1% move, Canaccord Genuity strategist Tony Dwyer was citing other signs of ragged tape action and subtle weakness in reiterating his call for a 5%-plus market correction (which he feels should be bought for a powerful surge to his year-end S&P 500 target of 2,185, up more than 11% from Thursday’s close).

A time-proven gauge of internal market energy, the Lowry’s Buying Power index, has sagged to the lowest reading of the year. And despite the headline indexes being right up against all-time highs, fewer than one quarter of New York Stock Exchange names were within 2% of a 52-week high.

Such indicators “tell us the broad market is already in correction mode,” Dwyer says. “Many times, the correction shows up in the mega-cap stocks and major market indexes toward the tail end of a market correction.” Of course, in the springtime the damage never hit the headline large-stock benchmarks hard, as what I call an "immaculate rotation" shifted money from aggressive stocks to stable, bond-like shares instead.

The already-substantial pain in smaller-company stocks could even mean this trend of small-cap underperformance, something that often occurs later in a bull market, might not have quite as far to run in the immediate future as the growing consensus seems to believe.

Will Nasgovitz, portfolio manager of Heartland Select Value Fund (HRSVX), who hunts for inexpensive, out-of-favor stocks of all sizes, says, “It’s unfair to make a blanket statement about elevated [valuations] of small caps.” He says it’s mostly the lower-quality, more speculative subset of small stocks in the Russell 2000 index that are making the whole category appear overvalued. Indeed, the iShares Morningstar Small-Cap Value ETF (JKL) has handily outperformed its all-inclusive Russell 2000 counterpart during this choppy period.

Worrisome optimism

A nagging vulnerability of the market coming into the summer has been the pervasive optimism among active investors and traders. The proportion of investment-advisory newsletter writers tracked by Investors Intelligence who were bullish on stocks has been near historic highs since May, and the Bank of America Merrill Lynch global fund manager survey this month showed the second-highest tilt toward equities in 13 years.

Michael Hartnett, global strategist at Merrill and steward of that survey, has been firmly and correctly bullish on stocks and other riskier assets in recent years. Yet the fund manager ebullience – along with Merrill retail wealth management clients riding their highest equity allocation in at least nine years – prompted Hartnett to say Thursday that “an autumn correction is increasingly likely.”

As noted, of course, persistent predictions of a true, cleansing correction that pares stretched valuations and tempers investor expectations have failed to take hold since late 2012. The list of would-be or actual crises overseas that put a fleeting scare into the market includes the Cyprus insolvency episode, the Arab Spring, Syrian civil war, Iraq insurgency, Ukraine-Russia conflict and the current Israel-Hamas conflict.

If the current bout of unnerving foreign unrest proves a catalyst for a deeper and more inclusive Wall Street pullback, it will likely be more excuse than cause. The annals of major bull market tops and subsequent bear markets are generally free of pure military or geopolitical triggers.

The fact that the market conversation is now focused on whether or when a correction might arise – rather than whether a severe and prolonged market downturn is on the way – reflects the general sense that leading indicators of the economy are relatively encouraging.

Credit markets, while a bit softer lately, are far from signaling economic distress to come. Stocks are more expensive than the historical norm, but not dramatically so. Earnings have held up OK, even if they're no longer growing rapidly. And corporate animal spirits, in the form of capital spending and mergers and acquisition activity, are on the rise yet haven’t tipped over to recklessness.

One sign that prior periods of news-driven market setbacks have run their course has been a spurt in trader anxiety, which has tended to well up forcefully with fairly shallow 2% or 3% index dips. There were some hints of this Thursday, with a rush for protective stock options driving the CBOE Volatility Index smartly higher - a jump well in excess of what would generally accompany a 1%-ish daily market drop. And the CNN/Money Fear and Greed Index sinking fast toward extreme fear.

One of these times, such familiar tactical signals for buying a dip won’t work and the market will break rather than bend. Are we there yet?