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If this were 2013, the market correction would be over. But now?

Michael Santoli
Michael Santoli
If this were 2013, the market correction would be over. But now?

If the 2014 stock market were playing by the rules of 2013, then the recent gut-punch decline has been swift, deep and fright-inducing enough to reset over-optimistic expectations and gather up strength for a renewed climb before too long.

This, admittedly, is a big “if.” Last year's tape was among the kindest to investors in recent decades, a broad and steep 30% advance in the headline indexes with only the briefest and most modest downside interruptions.

With Federal Reserve policy in transition to a less-generous mode, stocks somewhat more expensive based on corporate profits and the bull market another year older, 2013 might indeed prove to have been the “easiest year of this bull market," as I wrote here in November. Marginally less Fed stimulus, hints of a less-aggressive Bank of Japan and several other measures imply this could be a year with somewhat more volatility in the indexes and churning beneath the surface.

The 5.8% drop from the Dec. 31 all-time high in the Standard & Poor’s 500 index was almost precisely the same magnitude as the May-June setback of last year. That stumble was prompted largely by the Fed’s initial hints that it was looking toward “tapering” its pace of monthly monetary stimulus and the resulting jump in bond yields.

The rude start to a year that was greeted with an excess of optimism and a certainty that the bullish trend was sturdy has nicely prompted an active “fear” response. This, in contrary fashion, is a positive sign, indicating that undue complacency was wrung out to a large degree.

The outflow last week from U.S. stock mutual funds hit a record $18 billion, says Citigroup, a remarkably skittish flight from risk with stocks mere weeks and 5% from an all-time high.

Ryan Detrick of Schaeffer’s Investment Research, who keeps watch of a crowded dashboard of investor-sentiment gauges, says, “This is a new year and 2013 was very special. Nonetheless, we’re seeing some of the same traits we saw last year” during the relatively brief market pullbacks.

He points out the percentage of investment advisors tracked by Investors Intelligence saying they expect a market correction exceeded 35% at last report, which happened in late June 2013 and only 34 times since 1990. Subsequent returns after prior instances were significantly better than average for stocks over two, four and eight weeks.

Similarly, the National Association of Active Investment Managers showed a huge decline in equity exposure, a flight instinct at work, and the volume of hedging in the top index exchange-traded funds and total short interest are quite high.

The rebound since Monday’s 2% drop has also had a familiar cadence. Larry McMillan, who runs market-research firm McMillan Analysis, observed Friday morning: “Yesterday’s daylong rally was reminiscent of the 2013 bull market, where [the S&P 500] jumped higher by about 20 points and then just stayed there all the rest of the day – edging even higher near the close.”

The way volatility measures surged and then sank back quickly this week is also reminiscent of other recent periods when a market “fever” builds and then breaks.

The fact that stocks advanced Friday following an employment report that mixed both sobering and encouraging evidence of the economy’s strength is a hint that the market is willing to look on the bright side of things in the absence of a clear slowdown trend or ever-escalating stress in emerging markets.

Wayne Kaufman, chief market analyst at Rockwell Securities, says, “This pullback was a little more than I expected so soon, especially coming during a supposed catalyst of earnings season. It may end up being garden variety pullback that just erases the window dressing rally from mid-December” to the end of the year. About half of all large stocks fell at least 10% from high to low, alleviating the upside overshoots in many pockets of the market.

One significant difference between now and last summer is that stock valuations comapred with earnings were appreciably lower (less than 14-times forecast earnings) than they are now (around 15.5-times this year’s estimates). Treasury yields are similar -- 2.58% on the 10-year note then after a rapid surge, and 2.66% now after ebbing from near 3%. And the profit-growth landscape is proving a bit more treacherous, with plenty of notable land mines courtesy of some growth-stock favorites, such as Twitter Inc. (TWTR) and LinkedIn Corp. (LNKD), not to mention General Motors Corp. (GM).

It’s also true that last year’s June decline in itself was arguably an “incomplete” correction, one that didn’t carry on deep or long enough to refresh buying power in the typical way the market does.
The perception that the Federal Reserve would respond to any sign of economic slowing with more monetary help was strong. This year, the Fed is attempting to do less, and officials keep insisting the threshold for the bank to reconsider or pause its tapering is rather high.

What’s more, the weakness recently has occurred in January, a seasonally strong month historically, rather than in spring and summer, which often see choppy action or worse. When the market fails to follow historical tendencies, its message about a possible change in tone is a bit stronger than when it does what it’s “supposed to” do.

No year clearly shows its true character in its first five weeks, making it tough to bet aggressively that the bullish 2013 playbook has the answers. That, as the sports announcers say, is why they play the games.