Healthy Pull-Back?

The media were all abuzz following yesterday’s much-anticipated sell-off in stocks. Prior to yesterday’s 1.5% drop, the S&P 500 had gone 44 straight days without a sell-off of 1% or more – the longest such streak since May, 2007. Over the same time, the VIX index, which provides a market estimate of future stock volatility, cratered to multi-month lows. The VIX falls when fear subsides. Therefore, to say that complacency had crept into the market may be an understatement. With increasingly strong employment data and no sign of the Fed removing its foot from the gas, investors plowed ahead into stocks and took the S&P 500 to multi-year highs. The S&P 500 has now risen over 100% since the lows of March, 2009, and many (if not most) market pundits say we are headed significantly higher by year’s end.

But due to the relentless buying of late, a correction has been considered overdue by many professional traders. Such a pullback, absent any other issues, would be considered healthy for a market that has become so hot. Generally, these “healthy” corrections could be good for 5%-10% declines in the major market averages. This would suggest that more selling may be ahead if we are indeed experiencing a normal and healthy correction. Indeed, many professional traders would actually be encouraged by a pullback of this magnitude. It would allow investors to consolidate their gains, regroup, and prepare for the next leg higher.

Our concern has not been that the market is going higher. We continue to believe that high-quality stocks may be the best investment alternative in a world of 2% long-term Treasury yields. Rather, our concern is that the Fed may be keeping the training wheels on for far too long. The Fed’s support, explicit or implicit, creates a moral hazard among stock investors. If investors feel that the will be bailed out by QE3 or other Fed action in the event of a sell-off, this will lead them to take on more risk than they otherwise would. Moreover, the Fed’s maintenance of super-low interest rates can force investors into riskier assets in an effort to improve returns. These types of behavioral responses to Fed action can lead to asset bubbles if allowed to go on too long. They can also keep the market from undergoing a normal and healthy correction.

The good news is that a closer look at the action within S&P 500 suggests that sentiment overwhelmingly favors the notion of economic recovery. The sectors driving the index higher are the more cyclical and volatile ones that professional investors usually target in an effort to get the most bang for their investment buck during periods of economic recovery. For instance, the Information Technology, Financials and Consumer Discretionary stocks are all outperforming the overall index so far this year. Earnings within these sectors would generally be expected to benefit to a much greater extent from an economic recovery. On the other hand, Utilities, Telecom, Consumer Staples, and Health Care – sectors considered more defensive in nature – have lagged the overall market so far this year.

S&P 500 Sectors YTD Change
Information Technology 14.2%
Financials 11.5%
Consumer Discretionary 10.2%
S&P 500 7.2%
Materials 7.2%
Industrials 6.7%
Energy 4.9%
Health Care 2.8%
Consumer Staples 0.9%
Telecom 0.1%
Utilities -4.4%
Source: Bloomberg

It is not uncommon for investors to hope for a near-term correction so that the long-term upward trend is maintained and indeed strengthened. In our view, investor reluctance to sell is a sign that greed has been far outweighing fear. And a relative lack of fear MAY be a sign that investors expect help if they get into trouble. As long as Big Brother Fed is around, investors should take their outsized stock gains with a grain of salt.