Three Reasons for Optimism

Over the last 5 trading days, the S&P 500 fell 8.5%, its sharpest fall since mid-2011. Such a sharp and fast drop always creates a counter-rally, but gauging the timing is never easy. Market players are overcome with intense emotion – and that being the case, it’s hard to be objective about how things are unfolding.

We can state with a high level of confidence that the slumber in the market is now over. From November 9, 2016 – February 1, 2018, the S&P 500 traded at an average daily range of just 0.6%. But ever since February 2, we’ve seen the trading range soar to 3%. Active day traders love this – seeing that the current trading environment enables strong and large movement in both directions. Of course, on the flipside, long-term investors are worried about the prospect of a deep price correction. That reality is all the more salient considering that all of the large indexes officially entered “price correction” territory last week, now trading 10% beneath the all-time high recorded in January.

Last week’s market movement was the most dramatic we’ve seen since the 2008-9 collapse. The drop from the all-time high on January 26th was the largest and fastest drop in market history!

It could be that the best way to comprehend the extent to which the latest market movement was brutal – and structural at its core – is to simply glimpse at how all of the stocks on the market, like one big juggernaut, fell all at once. There was nowhere to hide. No place to duck for cover.

What that means that stocks were not sold in relation to their underlying qualities, but rather, were tossed over the cliff, institutional players looking to close positions – and fast!

The major indexes succeeded in soaring towards Friday’s closing bell, against the backdrop of hope that most of the selloff is behind us and that investors will again be able to focus on choosing attractive stocks. In our estimate, there will continue to be high volatility levels for the impending future, but we can also expect to see investors selecting the stocks with strong fundamentals, which will draw greater market inflows.

Some of the market experts believe that the latest movement is the beginning of a marked turning point on indexes, which will catalyze a long-term downtrend. That thesis relies on the thinking that higher interest rates will serve as a headwind that the market won’t be able to overcome. The thinking goes that central banks artificially engineered a strong stock market and that the time to pay up is now.

We, though, don’t believe that that is the case before us. In effect, our take is that the market will gradually return to show its resistance, and that incrementally, one step at a time, it will try to return to new highs. This optimistic stance hinges on three factors:

  1. The price correction reflects little more than the surfacing of many structural problems created after the artificial boost in the market. Over the years, the market was spurred on by algorithms and sophisticated trading programs that represented a deviation from normal trading movement. It was easy to pick up this in the form of constricted volatility created by literally trillions of dollars traded through these sophisticated machines. This trading system made virtue for its clientele by virtue of the fact that the market moved slowly and stably in a unidirectional way. The market is now not only dealing with the constricted volatility but rather another form of computerized trading which changed the normal market dynamics. It will take time, but when push comes to shove, we expect to see a change in the character of price movement on a daily basis the more this process develops.
  2. Despite the fact that interest rates were one of the main catalysts for the latest correction movement, there wasn’t a substantial change in the economic picture or in fundamental figures. The new tax bill will spur huge corporate profits that will give U.S. firms a bullish tailwind – and there’s no sign that the economy is slowing. Business optimism is at high levels and when the market focuses on the merits of individual stocks, there are many defensible bullish arguments.
  3. The price correction movement has been propelled mostly by the indexes and other structural reasons. What we’re seeing now is very different from what transpired in the years 2008-9 and 1999-2000, when the main issues were high valuations and a substantial change in the economy. What we’re seeing now is the market freeing itself of some of the refuse or negative aspects of our current marketplace – but what we’re seeing is not a change in the economic environment.

As of now, the right game-plan takes patience. Don’t try to take the first bite out of the cake, the moment you think the market has bottomed. The first thing one should do is to refine your stock wish list, the more price movement improves. Many stock reports released solid earnings numbers backed up by a positive narrative, though these stocks too were ripped to shreds when the latest market panic set in.

The advantage of a selloff in a market like this, the selloff we in fact just saw, is that price evaluations become inefficient. The market doesn’t take into account the merits of each individual stock in situation like this. All of the stocks on the market head to the chopping block and are brought back down to size. When the ill-feeling slightly subsides, the new market leaders will appear.

It was a painful week for the market, but by the same token, we are no less excited about the trading potential around the corner. It’s been quite some time already that we’ve been yearning for higher volatility as well as the neutralization of the effects of artificial trading devices. And that’s to create a healthier market. The process isn’t easy, but the market will come out the better for it.

Have a great trading week!