Client Note {Part I}

Below is Part I of a note I sent to clients yesterday.  It is in a question and answer form, mirroring queries I've received from clients in the past few weeks.

What’s been going on with the stock market?

The character of the stock market changed at some point in 2015.  While certain large capitalization indices like the S&P 500 and the Nasdaq composite posted positive returns, almost everything else failed to keep pace. Currently more than half the names in the S&P 500 are down by more than 20%.  If you broaden this out to the S&P 1500, then the average stock in that index is down nearly 27%^ and it’s worse when looking at smaller cap issues.  Three things have been bothering investors, slowing growth in China and how that has affected other emerging markets, the decline in oil and slowing earnings growth here in the United States.  Stocks already traded at stretched valuations so this has made investors skittish about prices.

So are we in a bear market?

I think the verdict is out on a bear market although; there’s been a lot of talk about that by the financial press.  Part of the reason this is less clear-cut is that the US economy keeps puttering along.  We will probably see GDP growth of 1-2 % this year.  Growth might be better if oil prices quit declining.  We’re also at 5% unemployment {although there’s debate on the real number of people without jobs}, inflation remains low and consumers have shown the willingness to open their wallets when they perceive value.  We set a record for car sales these past two years, while housing has also been robust.  Certainly there have been parts of the world and market sectors that have been in a bear market-energy certainly comes to mind.  Energy ETFs are down almost 50% from their highs so that means there are a lot of individual companies in those underlying groups that have declined much more than that.  The S&P 500 is down about 11% from high’s set last May.  That’s painful but around historic averages when measuring market corrections.  However, the tenor of the market has changed and that’s something we have to watch closely and factor into our portfolio analysis.  

What do you mean by tenor of the market changing?

Investors bought each market dip until last summer.  You can see that in the weekly chart I’ve provided with this letter.  Market corrections tended to be short, shallow and met by buyers who perceived value.  That’s changed. It’s not necessarily important why that change came about, but it is important to realize this change in investor mentality.  First, a point we discussed several times in the fall, there’s a significant level of price resistance now around 2,100 on the S&P 500. {See Chart included below and the area highlighted in yellow.} This pattern now goes back about a year and represents investors who bought at higher prices and now hold losses. Theory states that those “trapped longs” are likely to become sellers as we near their old purchase prices.  That’s a wall of resistance that we haven’t seen for years and will likely need some better economic results and better investor sentiment to be overcome.  Also investor mentality has changed.  Market declines are not being bought or at least they haven’t been at higher levels. We are also seeing lower market highs and lower lows, the opposite of what occurs in a bullish phase.  That pattern needs to change and stocks probably need to build some type of base before they can start to advance again.

Long ETFs related to the S&P 500 in client and personal accounts, although positions can change at any time.

Chart is from Tradingview.com.  Annotations are mine.

^Zero Hedge:  The Average Stock is Already Down 20%