Friday, October 30, 2009

The Stock Market Pullback: A Primer

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

I had originally intended to follow up last week’s post on deflation with one on inflation. But in light of the emails I received about the posts prior to that and the stock market’s recent behavior, I decided to postpone the inflation piece until next week and talk about what’s more relevant now, the market’s pullback.

On Oct. 22, I contributed with an article entitled, "Storms Brewing for the Stock Market," that was followed up with another one on Oct. 16 called, "The Dow at 10,000: Is It Time to Celebrate?" My thesis was consistent in both posts, calling for the largest decline since the rally began in March during the second half of October into early November. Once started, it should chop 7% to 17% off of the major indices, which is 700 to 1700 Dow points. With stocks coming under the most pressure since early March, a number of folks emailed me to discuss the reasons behind the decline and if I saw a change on the horizon.

Let’s start with the decline. Generally speaking, I refer to anything less than 10% as a pullback or counter trend move. Once we hit 10%, I will call it a correction. There’s no science or textbook to back this up. It’s just what I’ve been doing for most of my 20+ year career. And you are welcome to use your own labels.

During bull runs, like the one we’ve seen since March, short-term pullbacks can and do occur at any time. They typically last anywhere from a few days to a week and cut several percent off the major indices. This type of decline is the most difficult to forecast. A former boss of mine used to say that during the strongest markets, you should use any back-to-back bad market days to add to your position since it’s unlikely to get much more than that.

Once a bull run begins and is confirmed, a topic for a different day, it is HIGHLY unusual for the market to pullback more than a few percent for the entire first leg higher. A new bull run always begins with a heavily oversold stock market and the initial days of a new bull run are usually dismissed as nothing more than a bounce in an ongoing bear market. When that “bounce” doesn’t stop, but powers ahead with force, bears throw in the towel, forcing even higher prices. Realization sets in that that something has definitely changed and investors look for any opportunity to get on board.

The last three major bull runs, beginning in October 1998, March 2003 and March 2009 saw near vertical rallies at the outset from several weeks to months. To go a step further, it’s VERY unusual to see a 10% decline during the first 9-12 months of a new bull run. If we do end up seeing a correction in 2009, that would be a very worrisome sign for the long-term sustainability of this bull run.

Getting back to the topic at hand, 10% declines typically do not come out of thin air. The market has a habit of warning investors several times before weakness sets in, but few heed those warnings. I often refer to the chance of a correction as a window of opportunity. It takes a lot to open that window and once open, the market must act or the window will close until next time.

In September, historically the weakest month of the investing year, some small cracks began to appear in the pavement that caused me to worry. But the market would have to rally hard in early and mid October for my forecast to have legs. And rally it did! From the Oct. 2 bottom to the peak on the 19th, almost every day was a winner for the bulls, on the surface.

Underneath the surface was a different story. A month in advance, I called for the ultimate high to come during the week of Oct. 12, my window of opportunity. That period held interest for me because a number of market cycles were showing peaks then. It was also the week of options expiration, where stocks often trend in the same direction as the previous four weeks but reverse soon thereafter. On top of that, it was the first big week of Q3 (third quarter) earnings reports. Last quarter, stocks were soft into that week, but turned around on a dime, rallying strongly for the rest of earnings season. Back to back, powerful earnings rallies are rare so the odds favored at least a pause in the rally, if not full reversal.

To really see weakness so early in the new bull run, many other ingredients are necessary. Volume - the horsepower of the market’s engine - should be exploding higher, but it’s actually receded during the last leg of the rally. Sector leadership, the lifeblood of a bull run, began to show tiny cracks in early October, saw large holes form as semiconductors, telecom, and networkers are all rolling over in tech land. With the homebuilders exhibiting smart money selling for a few months and biotech, transports, industrials and materials all underperforming and rolling over, there's not much left to hold stocks up.

One of my favorite market expressions: “The most bearish thing a market can do is go down in the face of good news,” has been ringing true since earnings season started. Bellwethers like Intel, JP Morgan, Apple, Microsoft and Amazon all beat earnings expectations by a wide margin, yet all the market could muster was a brief rally early in the day before serious selling waves hit.
Sentiment, the number of investors exhibiting or expressing firm opinions on the market’s direction, had become very positive, which typically is a sign of an uptrend about to reverse. Conversely, after a significant decline in stocks, investors become very negative, usually after they’ve already sold, setting up the market for a reversal.

Finally, at the end rallies, we normally see the major indices, like the Dow, S&P 500 and NASDAQ hold up in price, while the internal measures of these have deteriorated. To use a military analogy, the officers and ones in charge continued to battle and show a brave face, while the troops turned tail and retreated. While price last showed strength a few weeks ago, the number of stocks going up fell off dramatically along with the volume in those stocks.

The first leg of my forecasted correction is clearly here as stocks have been hit with the ugly stick for four straight sessions. The initial decline usually sees the weakest selling waves as bulls have not yet abandoned ship and bears are not yet convinced that this is anything more than a routine pullback in an ongoing bull run. The market is now supposed to try and stage a brief rally, lasting one to three days to relieve the very short-term oversold condition. If it does, I fully expect that rally to fail and lead to much lower prices in November. If a rally does not materialize, the market is in much worse shape than it appears and we will likely see the larger end of my 7% to 17% correction range.

It’s too early to forecast when this period of weakness will end, but my first read would be mid-November to early December. This is all healthy and normal and should lead to an entire new leg higher to the rally that began in March. I do not believe the bull run has ended, but we will let the market tell us that for sure.

Before finishing up, I want to add a few personal words. I happen to enjoy forecasting the financial markets very much. I love to compete and the market is the single most worthy foe. At the end of every single market day, week, month, quarter and year, I get to judge how I did in black and white. I may be a really great guy or complete jerk, but the market doesn’t care. The numbers are the numbers and I accept it.

I tell new clients all the time that when I am on target with my forecasts, they will likely think I am a genius, only to die by that same sword when the market turns on a dime. Short-term forecasting can be tough emotionally as the market does its best to confound the masses. When I manage portfolios for clients, I employ non-emotional, very powerful and robust models that dictate what to buy and sell along with when. It’s comforting when the models match my own forecast, as they have this month, but in the end, we rely on our time tested models first and human forecasts second.

Thanks for reading all the way to the end of this long posting. I hope you learned just one new thing that may help you in the future. Please feel free to email me any questions or comments to include in future articles (

Assuming nothing earth shattering occurs in the market, I hope to talk about inflation and why it’s one of last things I am worried about in the near future.

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