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It's now a bull with claws, as traders await a washout

Michael Santoli
Michael Santoli

The market owes us nothing – not even an explanation.

After rising for six-and-a-half years and reaching a generous valuation in a slow-growth world, big U.S. stocks had gone a long way toward pricing in a healthier corporate economy.

Perhaps the idea that the market owes us no more, that bullish investors were playing only for an “upside overshoot” beyond fair value, set the context for this nasty selloff of the past week. But that’s not very enlightening or helpful right now, as markets look to extend a sloppy selloff into a new week.

Yes, China’s currency devaluation and the disorderly descent of its stock market are the proximate culprits here. But emerging-market assets have been in a smothering decline, commodities were being liquidated and credit markets have been unsettled for months.

While the recent drop of more than 5% is quite “normal” in the grand scheme, it’s been rather sudden and feels more jarring because of the strange calm that preceded it during the flat seven-month “do-nothing” phase.

Now the broad market is making up for a monotonous plot by packing lots of drama into a brief period. Our market has gone from shrugging off global turmoil to throwing up hands in surrender to them.

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So here are a few things to consider as red fills quote screens this morning:

It’s now a bull with claws. We had gone a long while without at least a 5% decline in the S&P 500 (^GSPC) from its high. Now we got one in two days.

Note that we’ve had 48 5% pullbacks from an all-time high in the index since it was created in 1957. Seventeen of those deepened to 10%, and nine of the 48 turned into at least a 20% drop.

The odds still favor this being a bull market until proven otherwise. It’s not common to get more than a 20% drop in U.S. stocks – typically defined as a bear market – without a U.S. recession, and no such things appear imminent. But financial panics can cause swift damage near that magnitude, and the cycle of fear and flight from risk can be self-reinforcing for a while.

Looking at levels. The Shanghai Composite (000001.SS) cracked clear through the 3500 level that was once considered a place the government would try to defend strenuously.

The S&P 500 here laid waste to the 2040 level that had defined the lower border of its long trading range. It is likewise poised to slice through the 1970 mark, near December's low. Some see this move stretching down to 1880 or so before finding firmer ground. I’ve argued before that most of the upside from 1850 could be considered a typical bull-market overshoot, so maybe that’s where prices find stronger-handed buyers. Or maybe we don’t need to get down that far at all. No one should pretend to know.

The trend lines from the 2011 market lows and even the ’09 bottom are now appearing more vulnerable.

Fact is, levels are crucial until they’re not.

The real crucial thing is, we’ve gone from a market where prices change less than underlying circumstances to one where they’re changing faster than fundamental conditions. Can’t emphasize this enough: Nothing has changed as much as security prices in the past few days. When prices of assets fall, they become less risky for the longer term, not more.

Waiting for a washout. Now the would-be heroes are looking for signs that the selling has been too indiscriminate, and a washout is at hand that can be safely played for a ferocious bounce.

The makings are in place: We’ve never seen as fast a surge in the CBOE S&P 500 Volatility index (^VIX) of protective options prices as we have in the past five days. Tons of technical damage has been done. Market leadership for any new rebound will require battlefield commissions.

We’re relatively close to having the conditions for the kind of oversold bounce that will make investors wonder if another “V” bottom has been reached, as happened last October in the growth-Ebola scare. Seasonal forces are less friendly for a durable bottom in late August, though.

Sub-surface silver linings. Aside from the signs of severely oversold conditions, several nagging “divergences” have diminished. No longer are big stocks “ignoring” weak small-caps or sagging overseas markets or carnage in risky-credit markets. This is a net positive.

And most of the sectors most immediately affected by China, commodities and global industrial conditions have already been smoked. Finally, investors had already front-loaded a lot of anxiety, so sentiment is more conducive to a bounce.

The broad investor community never got truly giddy over stocks and has panicked over every 3% downside wiggle. In this context, a bad mood is a good thing, and in theory should insulate us from even more severe markdowns in prices.

Of course, even if the bull market survives this, certain core premises have still been rudely challenged: China as the provider of marginal growth in the world, Chinese authorities’ ability to steer the economy and markets there, the scripted transition by the Fed away from zero interest rates, the immunity of glamour growth stocks to broader market forces.

The adjustment to these shifts is necessarily jarring. But if you wanted that meaty market correction, the time has come to ask yourself what you want to do with it now as it approaches.

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