Is it Correction Time?

Tom Beilstein, CFA, Portfolio Manager

After a remarkable run over the last fifteen months, the stock markets have paused to take a breather. Following the market bottom on October 9, 2002, the S&P 500 had returned 48.7% through January 26, 2003. Since that relative high, the index of large-cap U.S. stocks has fallen 0.7%. Over the same period, the Nasdaq Composite had gained a whopping 93.3%, followed by a -6.7% return since its near-term peak. We now need to figure out if the market is pausing to prepare for its next forward move, or if it got ahead of itself and we are now poised for a correction. In this article, we will examine a number of issues that may help us answer this question.

Economy – GDP and Unemployment

There are a number of issues we can focus on when examining the economy. The first is GDP, which is the broadest measure of U.S. economic output. GDP improved greatly last year, growing by 3.9%, 4.0%, 5.4% and 5.9% in each of the last four quarters respectively. This has been fueled predominately by consumers, which means it should have some staying power as corporations begin to increase their capital spending budgets. Unemployment has been the one indicator that has been slow to improve. As GDP has grown by leaps and bounds, unemployment has only drifted lower. At 5.6%, we are more or less at the same unemployment level we experienced as we came out of the recession in November 2001 (Date provided by National Bureau of Economic Recessions). Although we have not seen the job growth we expected to see, we view the current state of the economy as a positive for the stock market.

Investor Confidence

Contrary to popular belief, the stock market tends to do best following periods of extreme pessimism and worst after periods of extreme optimism. So even though the market usually rises immediately following the announcement of a positive confidence report, in the long-term it means that we are closer to a peak. Ned Davis Research (NDR) calculates a crowd sentiment poll highlighting short- to intermediate-term swings in investor psychology. The composite reading shows what percentage of all the investors represented by the polled data can be classified as bullish on the stock market at a given time. When the index is above 61.5%, there is extreme optimism which is bearish for the markets. When the index is below 50, there is extreme pessimism, which is bullish. In late 2002, the composite had an extreme reading of 33.9, which occurred just around the time the markets began their current bull run. Currently, the reading is 66.2, which is down from the high of 75.7, which was reached in late January. This may help explain why the market has decided to take a breather. These high levels are a negative for the stock market.

Inflation and Interest Rates

Low interest rates are good for the economy and the stock market. Low interest rates allow consumers and corporations to borrow money cheaply. This allows consumers to buy houses and cars and corporations to expand their operations and upgrade their technology. But besides helping companies’ profits by encouraging more spending, low interest rates also aid the stock market by giving investors less options to achieve their total return goals. With money markets currently yielding approximately 1% and the 10-year Treasury yielding less than 4%, investors must find alternatives to meet their goals. When real interest rates are low, currently they are -0.3%, stocks outperform bonds by 8.7%. Investors realize this and seek these returns by moving more money into stocks. Since we have established that low interest rates are positive for the stock market, we must figure out if rates will remain low. This is why we have included inflation in the title of this section. The main reason the Federal Reserve will raise interest rates is to subdue inflation. Just as low interest rates spur growth, high interest rates temper it. Currently there is little inflation in the United States. As of 1/31/04, the core CPI stood at only 1.15%. This makes the Fed very happy and it will keep rates where they are until it sees the economy heating up. So this is our conundrum. If the economy heats up, it is good for earnings, yet could lead to inflation and higher interest rates. If the economy is sluggish, earnings may not improve but interest rates will remain low and the environment for future growth would be positive. So we should root for slow growth so that earnings will improve and inflation will remain tame (remember the soft landing). As long as the core CPI remains under 2%, it is positive for the stock market.

Politics - Elections

One thing we do have going for us this year is the election cycle. Historically, the stock market has had stronger performance during election and pre-election years than the post-election and mid-term years. The Dow Jones Industrial Average has averaged 8.0% in election years and has been up in over three quarters of the years. It is interesting to note that when a Republican incumbent wins, the market has averaged 14.6%, while if the incumbent loses, the market has averaged only 4.2%. The other benefit of this being an election year is that it increases the odds of interest rates remaining low. Greenspan endured a lot of criticism after the 1992 election that his increasing interest rates cost the elder Bush the election. He does not want that to happen again and will be hesitant to raise rates until after the election. The election cycle is clearly a positive for the stock market.

Money Flows/Liquidity

Due to the mechanics of the market, stock prices go up when there are more buyers than sellers. When net flows are positive, the market has gained an average of 9.7%. When flows are negative, the market has averaged -0.9%. Currently investors are buying. In January, the net flow of money into stock mutual funds (net sales minus redemptions using a 3-month smoothing) was $32.6 billion. But can these flows continue? We can never be sure, but there is certainly enough money on the sidelines to let us think it will probably happen. Money market fund assets currently total $2,052 billion, which is 18.4% of the Wilshire 5000 (the Wilshire 5000 is the broadest market index that includes both large and small stocks). Whenever money market assets are high, there is an opportunity for future flows to go into the market. In fact, when money market assets are greater than 12.8% of the Wilshire 5000, the broad index returns an average of 14.5% per year. Liquidity and money flow remain positive for the market.

Momentum

Most investors have heard of the expression “don’t fight the tape.” This implies that when the market is going well (or not so well), do not bet against it. There are many different trend and momentum indicators that one can look at, including a specific industry’s moving average, the number of highs and lows, and the rate of change to an industry’s price index. Because there are so many indicators to consider, NDR has created a composite called the Big Mo Tape Composite Model which is designed to give a reading on the technical health of the broad market. The model aggregates the signals of over 100 component indicators and generates a reading between 0% and 100%, reflecting the percentage of the component indicators which are currently giving bullish signals for the S&P 500 Index. When this figure is over 88%, the market has done extremely well. The current reading is 90%, which is positive for the market.

Summary

As you can see, determining the short-term direction of the market is an extremely difficult task (which is why market timers rarely succeed). We have touched on just a few of the indicators that analysts look at to determine the short-term direction of the market. We did not explore other pertinent factors such as the dollar and valuations (which would be another article in itself), but we must say that all of these could be superceded by war and terrorism. My instincts tell me that some sort of correction is on the horizon, but since a majority of the indicators still point towards a strong market, the correction will have to wait. Look for the markets to remain positive into the elections and then be prepared to take another close look at the aforementioned factors. At that time (early 2005), regardless of who won the election, the market may be poised for another breather.

Data sources: Ned Davis Research and Wall Street Journal.