Wheels Are Coming Off This Market

October 14, 2014 Updated: April 24, 2016

Yes, it’s a bit late to write a piece about the falling stock market after the S&P dropped 6 percent since Sept. 18. However, there are a host of indicators flashing red, signaling a deeper correction to come.

Since the last sizeable correction in 2011, you only had to buy at any and every dip of 5 percent and would have made money. The bears were talking about overvaluation and reckless speculation but were proven wrong again and again. This time is different.

The most important difference between this sell-off and others since 2011 is the Fed stopping its infamous quantitative easing policy. It will buy a maximum of $7 billion of Treasury securities until the end of October and that’s it.

The last time the Fed completely stopped its “Permanent Open Market Operations,” (POMO) was in 2011. The market cratered 15 percent and the Fed had to start its “Operation Twist” to stem the decline. In 2010, after the end of the first iteration of QE and another 15 percent drop, it was QE2 which saved the day. Since 2011 we haven’t seen double-digit drops in the S&P, and the market went up more than 50 percent. 

Days when the Fed buys securities in the market and expands its balance sheet are highly correlated with positive S&P performance. At the same time, periods where the Fed stops being active in the market have seen double digit declines.

No New Normal 

This would be fine if the Fed was stopping its stimulus because the economy is great. Despite a superficially low unemployment rate and low inflation, it’s not. 

Instead many valuation, technical and sentiment indicators have reached bubble proportions. Historically, they warrant a correction with or without Fed intervention before, during or after.

First, market darlings such as Tesla and GoPro have suffered declines of 20 percent or more. Second, the small cap index Russell 2000 hit its high in July this year and did not match the high in the S&P 500 from September. Until then, however, it had been the locomotive of the current upswing since 2011, rising almost two times as much as the S&P.

At an individual level, this is reflected by almost 50 percent of NASDAQ stocks having fallen more than 20 percent off their 52-week highs. For the Russell, that number stands at more than 40 percent. Last week, and before the recent dump, only 28 percent of all stocks on the NYSE traded above their 200-day moving average, a good indicator of a long-term trend.
In addition, several measures of market confidence broke down with the current correction. 

The first is the Chicago Board Options Exchange (CBOE) volatility index, called VIX. It uses options to measure how much the S&P 500 will fluctuate over the next 30 days. After reaching multi-year lows in July at 10.32, signaling investors to believe the market would keep going up, it quickly broke out to 22.79 after the sell off started. During dramatic corrections, such as 2011, it can reach as high as 50.

Another indicator using options hit an extreme not seen since Lehman Brothers went bankrupt, a rather rash move for a 6 percent correction. On Monday, 1.53 bearish put options were traded for each bullish call option, more than the 1.52 which marked the extreme fear of the Lehman panic in 2008. 

On the other hand, the general public seems to be oddly complacent. Pundits keep on talking about buying the dip and the stock market is still the talk of the town. The number of bullish newsletter writers outnumber the bearish ones by three to one, according to Investors Intelligence Service, which conducted a survey. The market saw a ratio higher than three before the crash of 1987 and the market top of 2007.

While market timing is inherently difficult and no single indicator is perfect, investors should brace for a rough ride.