More Than Just a Correction?

05/20/2010 4:41 pm EST


Jim Jubak

Founder and Editor,

Here’s the big question for investors: Is this just a correction—the usual and useful 10% or so drop that refreshes a rally for the next leg up—or something worse?

On Thursday, May 20, the Standard & Poor’s 500 Index took out support at its 200-day moving average near 1100. (It closed above 1070.) The next stop for this market is the February 5 intraday low at 1045. That’s another 2.3% drop from here.

As long as the market holds that level, this is just a correction. Painful. Costly. But contained and absolutely normal after a big stock market rally.

And if the S&P 500 goes below that level? Then we’re in uncharted territory. The market drop would be more than a correction, clearly. But what exactly would it be?

It could be a retracement of the normal one-third to 50% of the previous rally, the one that started on March 9, 2009 when the S&P 500 was at 677. That’s about 550 points below the market’s April 2010 top at 1209. A 50% retracement would be 1034 on the S&P. That’s not too much below the February 2010 low.

But it could be something worse. The rally that began in March 2009 could turn out to be just a relief rally, and the market could resume the bear trend that it abandoned—temporarily, it would turn out—in March 2009. It happened during the Great Depression. Could happen again.

It’s hard for me to see that return to the bear market scenario happening, however. For stocks to resume their pre-March 2009 bear trend, we’d have to see major economic setbacks in global growth.

Economic growth in the United States would have to not just slow while staying positive, but the economy would have to slip back into recession. The economies of emerging countries would have to crash as well, with growth in China falling to 5% and growth in countries such as Brazil and India slipping towards negative territory.

It could happen, but to me it seems extremely unlikely on the fundamentals I see in the global economy.

This isn’t to say that I think we’re in a long-term secular bull market. I think the huge debt in the developed world, the need to raise interest rates and taxes, and the demographic bulge as the world ages argue that the stock markets of the developed world are in for a long-term secular bear market decline. I just don’t see a crash back to 677 in a few months as part of that pattern. I think we’ll cook—but slowly.

It’s almost as hard for me to see any reason for stocks to stop at 1045. Almost, but not quite.

I certainly don’t see any real end in sight to the budget deficits in Greece, Spain, and France, and dangers they pose to the euro and to economic growth in the euro zone. This is going to take months to work out—if it can be worked out. (For more on why the euro crisis is so hard to fix, see this recent post.)

I also think the US economic recovery is fragile—especially with slower economic growth from Europe. (See my post on good news that the stock market is ignoring right now.)

Worry about the economy slipping back into recession isn’t going away. And the central banks of the developing world will be raising interest rates for months. (For more on when that might end, in Brazil at least, see this post.)

That will certainly slow growth in those developing economies, and it does raise the real possibility that some bank will overshoot and actually take a much bigger bite out of growth than intended.

So no, the worries aren’t going to vanish anytime soon.

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But there’s a difference between worry and fear. Stocks can go up when investors are worried. (That’s why they call it the “wall of worry.”)  Fear, however, leads to panic selling—to dumping every stock in your portfolio in favor of safe investments such as the yen or Treasuries. Fear is what the market is struggling against—and losing to—now.

And I can see reasons that fear might be peaking.

The Senate just voted 60-40 to close debate on the financial reform bill. That legislation now goes to the floor for a vote. Why is this likely to reduce stock market fear? Because the longer the bill was open for amendments, the greater the chance that something really damaging to banks and their bottom lines would get into the final bill.

The countries’ big banks can live with the current bill—or whatever emerges from the Senate-House conference, although they might not be happy about it. (Many of us, on the other hand, would be happier with some of these tougher amendments, I’d guess.)

This will start to take some of the fear out of financial stocks.

The euro actually rallied in late market action Thursday, going to $1.25306 from $1.2295. The rally was based on speculation that the European Central Bank would intervene to support the euro in the currency markets.

I think that speculation is wildly optimistic. Even if the European Central Bank does intervene, its actions will be half-hearted. This bank just doesn’t like to meddle in the markets by buying euro or the debt of euro zone governments.

But the rally in the euro today is still important. It reminded shorts, painfully, that betting against the euro isn’t a one-way trade. It suggested that the euro is capable of behaving like a normal currency that declines gradually while staging the occasional rally. I don’t think anyone was convinced by today’s action that the currency isn’t still headed down, but the fear of a panicky plunge has dissipated just a bit.

Is any of this really good news? Not really. But I’m interested in when the momentum in the bad news shifts—that moment when today’s bad news isn’t as grim and scary as yesterday’s bad news was.

What you need to feed a panic is a sense that everything is getting worse at a faster and faster pace, and if you don’t run for the hills immediately, you’ll be road kill.

I think we’re moving towards the point where things are just bad instead of terrifying worse every moment.

How’s that for being positive?  

Full disclosure: I won’t own shares of any company mentioned in this story.

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