It Looks Like a Typical Correction

The recent correction shook up investors, and that will be good for the markets in the coming months.

Before the correction, stock indexes had been on an extended upward climb. The climb became very steep in January.

Importantly, technical measures indicated stocks not only were overbought, but extremely overbought. That means the index was more than two standard deviations above its 50-day moving average. Other measures that were at extreme levels included the ratio of advancing stocks to declining stocks and the ratio of stocks hitting new highs to those hitting new lows.

Not only was the overall market extremely overbought, all but two sectors of the market either were overbought or extremely overbought. The only laggards were utilities and real estate.

All that changed in a hurry. The S&P 500 became extremely oversold by the end of last week. All sectors of the market were either oversold or extremely oversold.

The stock decline was broad-based. Often when market indexes have a big move, there’s a rotation within the market. Some sectors are declining while others are doing well. That didn’t happen this time.

The S&P 500 declined 10.2% from its high, but the average stock in the index was down 9.85%. Likewise, the largest stocks were down 10.61%, while the smallest stocks declined 9.87%. Pretty much anyway you want to slice the market, the losses were about the same. In other words, stock market diversification or avoiding the recent top performers wouldn’t have preserved much more capital than owning the index.

The good news is that corrections like this (which historically occur every 16 months) tend to be followed by positive returns. The corrections on average last a couple of months before the rebound begins.

Reinforcing a positive outlook for stocks is that the economy is doing well. Most of the recent data has met or exceeded expectations. Also, the recent tax cut will be a stimulus in the short run and increase growth.

We’re in the late stage of the business cycle. The middle stage of the cycle was extended this time, so the late stage also could last for a while. But the late stage is characterized by capacity constraints. We’re already seeing that with wage growth increasing and rising commodity prices. Higher inflation also is a characteristic of this stage.

Eventually, the Fed will have to tighten interest rates enough to slow growth and reduce inflation. That will come later. For now, we’re likely to see continued synchronized global growth and higher earnings. That should lead to more stock profits, as long as interest rates don’t rise faster than earnings. It is a bad time to own bonds, but stocks and commodities should continue to rise.

The Data

The Consumer Price Index shook up markets for a while. It rose 0.5% for the month, and last month’s figure was revised higher to 0.2% from 0.1%. The 12-month change is 2.1%. After excluding food and energy, the 12-month increase is 1.8%.

Producer Prices, released today, rose 0.4% as expected, bringing the 12-month increase to 2.7%. After excluding food and energy, the index still increased 0.4% for the month and was up 2.2% for 12 months. The number didn’t stir the markets.

A series of manufacturing reports were issued today.

The Philadelphia Fed Business Outlook Survey had another strong increase, to 25.8 from 22.2. That is well above expectations. This survey consistently has been stronger than the other regional Fed bank surveys and the data of economic activity.

The Empire State Manufacturing Survey declined to 13.1 from 17.7. This was much worse than expectations. It also is the fourth straight month of declines since a peak of almost 30 last October. Even so, the number indicates strong growth in the region.

Industrial Production was the only report of real economic activity and was less positive than the surveys. Production declined 0.1% for the month, and last month’s 0.9% increase was revised down to 0.4%. The manufacturing component of the report was unchanged. Manufacturing increased 1.8% over 12 months, which creates a serious contrast between this report and the various surveys of manufacturers.

Home builders still are positive. The Housing Market Index from NAHB was unchanged at 72. Any number above 50 indicates growth, so this reading says builders are very positive.

The Small Business Optimism Index from the NFIB rose smartly again, to 106.9 from 104.9. That brings it very close to the 13-year high reached last November. The view that “now is a good time to expand” hit its highest level in the history of the survey. Only inventories and expectations of higher real sales kept the index below the November high. Small business owners are optimistic almost across the board, expecting higher sales and increased wages.

Consumer optimism is reflected in their borrowing behavior. Consumer Credit increased another $18.4 billion in December, and November’s credit was increased to $31 billion from $28 billion. That makes November the largest month for borrowing in seven years. As has been the case for a while, credit card use had a considerable rise both months. Over 12 months, credit card use increased 6%.

Even so, retail sales declined 0.3% for January, and December was revised down to no change from a 0.4% increase. This figure is volatile in the short-term. November was a very strong month, so the three-month view of retail sales is a solid one.

New unemployment claims declined another 9,000 last week, which brought the four-week average to a 45-year low of 224,500. Claims increased 7,000 for the latest week to keep the number and four-week average near historic lows.

The Markets

The S&P 500 recovered 0.72% for the week ended with Wednesday’s close. The Dow Jones Industrial Average rose 0.22%. The Russell 2000 returned 0.87%. The All-Country World Index added 1.07%. Emerging market equities gained 2.89%.

Long-term treasuries fell 0.97% for the week. Investment-grade bonds declined 1.15%. Treasury Inflation-Protected Securities (TIPS) lost 0.46%. High-yield bonds dropped 0.62%.

The dollar tumbled 1.57%.

Energy-based commodities lost 0.49% for the week. Broader-based commodities returned 1.16%. Gold returned 2.85%.

Bob’s News & Updates

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