- The stock market is now in correction mode following the 6% decline last Thursday, June 11.
- The market’s strong internals going into last week’s peak suggest that this correction is just that, a correction within an uptrend.
- The sell-off was, in part, driven by fears of a second wave in COVID-19 cases as well as a new focus on the US election and what a possible political regime change might mean for stocks.
A correction: We knew it was bound to happen sooner or later.
These were the clues:
- The market was up 44% from the lows in less than 3 months
- Momentum was overbought
- Breadth reached an extreme (breadth measures the number of stocks going up against those going down)
- A complete-looking 5-wave pattern for the S&P 500
- A market that was trading well above even the ambitious 2022 earnings estimates
- An army of day traders, apparently bidding up nearly every stock on the planet
It was certainly not unreasonable to expect this market to take a step back after leaping 10 steps forward. It did so on Thursday, June 11, with a 6% decline that spared no index or sector.
The question was less about whether a correction would happen and more about the timing and context: Will a retracement be just that, a healthy consolidation that caps the first phase of a new bull market (like June 2009), or will it be the start of something more serious, i.e., a dreaded "W" or "L" that ends up retracing most of the gains? It’s unknowable in real time, which is why we search for clues in the charts.
Potential catalysts for last week's sell-off
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
The market's price discovery is a never-ending process, and that was once again on display last week. The catalyst? The most obvious one is the fear that a second COVID-19 wave is now underway, resulting from possibly premature reopenings by some states and compounded by concerns about contagion spread during the protests.
If we do see new coronavirus spikes, that would leave affected states with only bad choices: Close down again and suffer the economic consequences or stay open and suffer the health consequences. Not a good situation, and an unwelcome development for a market that just retraced most of its losses and was supported by a wave of retail investor speculation the likes of which we have not seen since 1999.
But there's an additional factor as well, as investors become more focused on the chances and potential effects of political regime change in November. Would a change in the power dynamic in Washington tip the balance between capital and labor? If so, what would that do to earnings and buybacks, and therefore, valuation? More on this later.
It's possible, though, that this may be nothing more than a cookie-cutter A-B-C correction that shakes the tree, clears the decks, and resets the market. That's what the market did following the 2009 low. Three months after the low and having rallied 40%, the S&P 500 corrected 9% and retraced a quarter of the gains. A repeat would take us to 2,950 or so.
With the market off its highs, the S&P 500 is no longer as far out over its skis in terms of the consensus 2022 earnings estimates. That's assuming that the 2022 estimates can be trusted, of course, but for now it's one of the few waypoints that we have.
The good news is that the 2020 earnings-per-share (EPS) estimates have flattened out nicely, and the next-12-months estimate (NTM) is even rising a bit. That suggests some stability on the earnings front, at least over the near term.
Overbought in every way
Last week, the week of June 11, was a milestone of sorts for the market. Per Bloomberg, some 44% of stocks in the S&P 500 had a 14-day Relative Strength Index (RSI) of more than 70. The RSI measures price momentum, so this shows that a large percentage of stocks had very strong momentum going into the 3,233 high.
At the same time (and perhaps for the same reason), the breadth numbers reached impressive levels as well, with 98% of stocks in the S&P 500 trading above their 50-day moving average last week. Market breadth measures the number of stocks going up against those going down.
The good news is that being overbought is not necessarily a bad thing, especially if it comes right after a major low. History has shown that this pattern of an overbought stock market following a major low can be the start of a bull market.
One important caveat: This assumes that the low is in, while we technically don't know that yet. But since the 1929–1932 cycle, the market has never rallied this strongly and retraced this much of a decline without being a new bull market. Then again, if "this time" was ever going to be different, it might well be during this crazy year.
My conclusion is that, unless the tape is totally distorted by day traders and/or the Fed stimulus, the combination of strong price gains and strong breadth coming off a major decline is usually a sign that a new bull market is underway.
Having said all that ... the market may be looking to the election
There is another less-talked-about narrative behind the sell-off: A focus on the chances of political regime change in November. Investors are wondering what this means for the market. If the COVID crisis combined with widespread demonstrations usher in a change of political control in Washington, how would that affect the balance between capital and labor?
If corporate taxes, which were recently lowered, rise and companies are penalized for buying back shares, how would that affect earnings and buybacks? If corporate taxes do rise and buybacks are limited, shareholders could get a lower payout, which, by definition, suggests a lower valuation, per the discounted cash flow model (DCF).*
That is, unless that lower payout is offset by a lower equity risk premium. (The equity risk premium, ERP, is the additional return that investors expect to earn over Treasury bonds or the risk-free rate of return.) In my view, that's not at all an implausible scenario given how low the risk-free rate is—i.e., the there-is-no-alternative (TINA) effect.
With these variables in mind, I created 4 new scenarios for the DCF below. The top row shows the same "swoosh" scenario that I have been using in recent weeks, while the bottom row shows an "L" scenario in which higher corporate taxes lower the after-tax earnings potential for companies.
Read Viewpoints on Fidelity.com: What shape will the recovery be?
From there, at the top left, I am assuming the same 90% payout ratio as has been the case in recent years (i.e., 90% of earnings are paid out to shareholders as either dividends or buybacks), and at the top right I put in a lower 75% payout. In the L-scenario in the bottom row I am using a 75% payout and a 60% payout.
That last scenario, with an L-shaped earnings recovery and much lower payout, should suffice as an extreme "Japan-style" scenario in which the pendulum swings all the way from capital to labor.
So what do these different scenarios mean for the valuation of the stock market? Well, it depends on the risk premium. The chart below shows the 4 scenarios against a range of ERPs (from 3.5% to 5.5%). The chart shows that at a 4.5% ERP, the market seems to be pricing in a swoosh recovery with a 75% payout.
In the event that the payout curve ends up flattening because of a shift from capital towards labor, it will take a decline in the ERP to 3.5% to keep the market at its current fair value. Again, that's not at all implausible in my view.
One of the internal dilemmas constantly playing out in my head (and probably, those of many investors) is reconciling what the market is saying versus what we think it should be doing. What it is saying (via the tape) is that this is an early cycle bull market that will keep on going. But that message is difficult to reconcile against what we see happening around us in the economy. But the market doesn't discount today. It discounts tomorrow.