Is the “Stealth Correction” Ending?

Some market participants have been cautiously anticipating a stock market correction for some time now. This supposedly overdue pullback has remained elusive so far, although it has kept many investors and potential new entrants on the sidelines. But appearances can... 

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            Mikio Kumada, Global Strategist at LGT Capital Management

            be deceptive. In fact, many major market segments have corrected significantly. Those who uphold the “buy the dip” principle will surely be able to find plenty of appealing investment opportunities.

            “Buy the dip” is a frequently-used bull market mantra, albeit one which even professionals often find somewhat difficult to act upon in an ideal manner. Thus far this year, those who had been bracing themselves for meaningful corrections, or countermoves of 10% to 20%, are quite possibly disappointed – at least as far as the biggest developed market indices are concerned. Neither the S&P 500, with a market capitalization of US$17.3 trillion, or 97% of annual US economic output, nor Europe’s Stoxx 600, which is worth US$11.8 billion, or 65% of EU gross domestic product, have seen meaningful setbacks this year. Instead, they went through a couple of moderate consolidations – i.e. pullbacks of less than 10% – which were rather quick and successively less deep, which in itself represents another typical bull market pattern. The S&P 500 saw two such setbacks, the Stoxx registered three.

            Ever shorter and shallower consolidations in the major indices

            Specifically, starting in mid-January, the S&P 500 lost 6.1% over 21 days. Then, it again shed 4.4% during 7 down-days in April. But in the meantime, the US index has rallied by 7.8% and 3.2% from the respective intraday lows reached during these consolidations. Moves in the Stoxx 600 have been similar in magnitude. The first drop began in late January and lasted for 14 days, also bringing temporary losses of 6.5%, the second came in March, lasted 8 days, and logged a drop of 5.5%, and the third followed in April, when the index shed 4.2% over just 7 days. By today, the Stoxx is trading 7.2%, 5.7%, and 3.9% above the corresponding lows. “Buy the dip” would certainly have worked – if one were able to exactly time these rather short and shallow market fluctuations.

            The real corrections have been rather “stealthy”

            Still, the absence of such presumably obvious buying opportunities in the biggest of indices should not deter us from entering or reentering markets at this stage, as many important markets and segments have actually undergone quite significant corrections. For example, Japan’s Nikkei 225 index is down 13% from its January high. Tokyo’s benchmark is once again among the cheapest, even as its member companies continue to log the highest growth rate. Even in the US, the Russell 2000, representing smaller companies, has lost nearly 11% since its February peak, followed by the tech-heavy Nasdaq Composite, with a drop of around 10%. Unsurprisingly, these indices were the top performers of 2013, with the Nikkei up 57% and the Nasdaq and Russell up 38% and 37%, respectively. Furthermore, if we dig deeper into the markets, many of the widely popular stocks, such as Tesla Motors or Facebook, have in the meantime fallen by a quarter to a third from their 2014 peaks.

            Bond markets suggest “stealth consolidation” is ending

            At the same time, government debt markets have had a surprisingly long phase of strength since the beginning of the year, which has significantly reduced long-term interest rates in most markets. In the US, ten-year treasury yields have fallen from 3% at the start of 2014 to just about 2.5%, which is the lowest level since October, when markets still seemed partly obsessed with the infamous “tapering” theme. With all due respect for the necessary balancing nature of countermoves, with US nominal GDP growing at about 4% per annum on average recently, this yield level is clearly too low. The same is true for Germany or Japan, where ten-year yields have now fallen to around 1.3% and just under 0.6%, respectively. With these long bond rates now reaching potentially important “bottoms”, equity markets that seem stuck in consolidation mode this year should also be closer to regaining upward momentum. Last but not least, a potential economic slowdown has probably been sufficiently priced in by markets already, while the actual outlook for the economy and corporate earnings in most regions has actually remained quite constructive in view.

            Different consolidation and correction patterns around the globe

            The table (PDF page 2) shows the extent and duration of this year’s corrections and consolidations in the largest equity indices in North America, Europe and Asia. The biggest market indices were relatively stable so far this year, going through two or three short and comparatively shallow pullbacks only. By contrast, last year’s strongest performers saw deeper and longer periods of weakness, which makes good sense. Hong Kong’s Hang Seng represents a cautionary exception. Among the more volatile this year, this index has been booking comparatively large and long-lasting setbacks, even after lagging the other markets last year. Overall, however, the market patterns in the Western markets and Japan remain consistent with our fundamental view that the underlying bull markets in these regions have remained intact. Consequently, as a rule, recurring phases of weakness offer attractive entry points.

            Bonds yields have fallen too much and should rise modestly going forward

            The second graph (PDF page 2) shows the yields of major ten-year government bonds. This year’s pronounced weakness in some equity indices, and the rather modest gains in the biggest benchmarks, i.e. S&P 500 and Stoxx 600, was accompanied by strong government debt markets. This is not entirely surprising, given that declining yield (i.e. rising bond prices) usually reflect increasing risk aversion and/or deteriorating perceptions of economic prospects, while equity indices such as the Nikkei and the Russell are among the most sensitive to changes in the earnings outlook. In Japan, long-term bond yields have halved again over the past year, starting from an already extremely low level. In Germany, they have fallen by about a third. But even the comparatively modest drop in US treasury yields (by 50 basis points to a comparatively high level of 2.5%) is overdone. These levels are not in line with the actual growth and inflation outlooks in any of the aforementioned countries. The policy biases of the respective central banks are also at odds with sustained declining trends in long-term interest rates. Therefore, this bond market rally was most likely a partly “technical” and temporary development – once it is maxed out, we should also see upward momentum returning to the growth-sensitive equity indices.

            Source: ETFWorld –  LGT Capital Management

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