S&P 500 Weekly Update: Irrationality Isn't Always Associated With 'Exuberance' And 'Euphoria'

“Corrections only are considered “natural, normal, and healthy” until they actually happen.” ….Tony Dwyer, Canaccord Genuity.

From the view at 30,000 feet, the recent volatility and pullback is all part of the regular ebb and flow that occurs in the stock market. Yes, we just witnessed a pullback greater than 5%, and it was the first such decline from a closing high for the S&P 500 since before the election last November. Fear showed up and the pullback morphed into a dip into correction territory for the major indices. Problem for bullish investors, it all happened in a week.

The period from when President Trump was elected through Friday, February 2nd, is one that any investor alive today is unlikely to experience again in their lifetimes. 448 days without a 3% decline.

Source: Bespoke

Much to the dismay of the naysayers, when a streak like this ends it doesn’t usually signal a market top.

Source: Bespoke

Since no one can accurately predict stock prices, my belief is an investor has to look at the probabilities of events occurring. Regular readers know that to formulate the probability of something occurring, I like to view market history to form an opinion. Let’s take a look at some history that could be telling us to prepare for some volatility and weakness in stock prices in 2018.

Ryan Detrick, Senior Market Strategist notes;

“Midterm years tend to be a banana peel for markets, as they see the largest pullbacks out of the four year presidential cycle. However, those who hang on for the ride tend to see a significant bounce over the next year.”



Taking a closer look, since 1950, the S&P 500 Index has been down 16.9% on average at its intra year low during midterm years, though it tends to bounce back, posting an impressive 32.0% average gain over the subsequent twelve months.

So investors seem to have a choice now. Lean to the short term scenario that is always accompanied by “noise”, or look down the road as to what is really driving equity prices over the longer term.


OK, IF that occurs here in 2018, it says we could see a decent draw down this year, then the indexes could resume their upside momentum. Then again, consider the possibility that we have just seen the dip with a decline of 12% from the high to the intraday low on Friday. For a long term investor, this is just a shrug of the shoulders, a so what, a yawn and a how is the weather moment. For the nervous short termers and the investors with one foot out the door (and they are plentiful) this is a horror show, wrought with all sorts of fear and emotion. The latter will get whipsawed and more than likely be unsuccessful in over thinking and over managing their money. Not to mention the cost of their tranquilizers.


Two streaks for the S&P were broken in this sell off. The long skein of consecutive days where the S&P 500 traded above its 50 day moving average, the S&P 500’s 578 calendar day streak without a 5% decline from a closing high, both went down.

This market’s run of over a year and a half will go down as the S&P 500’s second longest streak without a 5% decline on record. The only streak that was longer was the 593 day streak stretching from 12/18/57 through 8/3/1959.

There have been ten S&P 500 streaks without a 5% pullback (blue line) along with how the S&P 500 traded in the year that followed the end of each streak. While the end of these streaks was not typically followed by a deep decline, the amount of time it took for the S&P 500 to get back above its prior peak ranged anywhere from a month (1943 and 1955), to up to nearly two years (1961).

Since I have often brought up the last secular bull market and a period from the mid 90’s as comparisons, the following chart shows how the S&P reacted after the streak ended then.

Source: Bespoke

A period of consolidation with volatility. The streak comes to an end (blue line), then sideways action before a new uptrend (red line) takes over. Let there be no doubt, we do have a total reset in the minds of investors now. This change has occurred seemingly overnight. That is the reason for my view on consolidation and volatility being the condition for investors to face in the short term that could indeed mimic the time frame in the graphic shown above.

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Economy

Last week, the commentary on GDP was;

“The Atlanta Fed tracker made some news last week with a prediction of 5.4% Q1 GDP growth.”

That headline may have added to the worry that economy was heating up too fast and causing the Fed to panic and raise rates. Well, as suggested this outfit changes their ideas, thoughts, and reports, like we change our socks. So now it appears things have cooled off;

“The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2018 is 4.0 percent on February 6, down from 5.4 percent on February 1.”


January ISM services index bounced 3.9 points to 59.9, a new record high, after falling 1.3 points to 56.0 in December (revised from 55.9). The employment component surged 5.3 points to 61.6, also a new all-time peak, from 56.3. New orders climbed to 62.7 from 54.5.

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December JOLTS Job Openings report was a non event at 5.81M vs. consensus of 5.90M. Jobless claims remain at levels not seen since the ‘70’s.

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Global Economy

J.P.Morgan Global Services PMI remained at ihg levels matching the 26 month high lat October. David Hensley, Director of Global Economic Coordination at J.P.Morgan;

“The global service sector made a positive start to 2018, with output growth improving and the upturn broad-based by both sub-sector and nation. Stronger inflows of new orders combined with rising business confidence and job creation all suggest that the sector is on course to maintain this robust upswing during the coming months.”

J.P.Morgan Global Manufacturing & Services PMI hits a 40 month high. David Hensley, Director of Global Economic Coordination at J.P.Morgan;

“The world economy sustained its strong upturns in output and new business at the start of 2018, as manufacturers and service providers benefitted from a synchronised upswing in global market conditions and growth. Forward looking indicators such as new orders, backlogs of work and business confidence also suggest that this solid phase of expansion will be maintained in coming months.”

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IHS Markit Eurozone Composite PMI is at a 12 year high. Chris Williamson, Chief Business Economist at IHS Markit;

“At 58.8, the final Eurozone PMI for January came in even higher than the earlier flash estimate, registering the strongest monthly expansion since June 2006. If this level is maintained over February and March, the PMI is indicating that first quarter GDP would rise by approximately 1.0% quarter-on-quarter.”

Germany contributed to the strong Eurozone reading as their PMI came is at a seven year high. France results on their PMI readings remain elevated as well, staying near cycle highs. Spain show the fastest pace of growth in six month.

German industrial production Increased 6.5% In December to close out a positive year of growth.


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Caixin China General Services PMI grew at the fastest pace in seven years. Dr. Zhengsheng Zhong, Director of Macroeconomic Analysis at CEBM Group;

“The Caixin China General Services Business Activity Index rose 0.8 points to 54.7 in January, the joint-best reading since October 2010. “The new business sub-index continued to inch up, although by a smaller margin than in the previous two months, reflecting solid demand for services. The input prices subindex hit the highest since April 2012, due to the impact of rising labor costs and increasing crude oil prices.

“However, the sub-index of prices charged went down again last month, suggesting that providers of services have failed to fully pass higher costs on to consumers. The Caixin China Composite Output Index increased 0.7 points to 53.7 in January, pointing to continued improvement in the operating conditions of both the manufacturing and services sectors.”



India Services PMI rose at its fastest pace in three months. Aashna Dodhia, Economist at IHS Markit;

“The recovery across India’s service sector continued during January, with growth in output picking up to the joint-strongest since June 2017 as underlying demand conditions improved. That said, the overall performance of the service sector remained weaker than the long-run growth trend.”


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Japan Services PMI rises to a three month high. Joe Hayes, Economist at IHS Markit;

“January PMI data shows continued growth in Japanese service sector output. Indeed, activity rose at a faster pace amid a stronger expansion in new business inflows. This supported forecasts of further economic growth by panelists, with business optimism strengthening to a 56-month high.”

“Input cost inflation accelerated to the sharpest rate since August 2008, with higher food and fuel expenses cited as a principal factor behind the uptick. However, demand growth spurred on firms to raise output prices at the fastest pace since May 2014. The Bank of Japan does not expect the 2% target to be attained until at least April 2019, with December 2017 core CPI rising at an annual rate of 0.9%.”

None of that global economic information is indicative that growth is slowing down.


Earnings Observations

Earnings continue to come in extremely strong, so results from corporate America were not to blame for the volatility and sell off.

Factset Research Weekly Report;

  • Earnings Scorecard: For Q4 2017, with 68% of the companies in the S&P 500 reporting actual results for the quarter, 74% of S&P 500 companies have reported positive EPS surprises and 79% have reported positive sales surprises. If 79% is the final number for the quarter, it will mark the highest percentage since FactSet began tracking this metric in Q3 2008.

  • Earnings Growth: For Q4 2017, the blended earnings growth rate for the S&P 500 is 14.%. All eleven sectors are reporting earnings growth for the quarter, led by the Energy sector.

  • Valuation: The forward 12-month P/E ratio for the S&P 500 is 16.3. This P/E ratio is above the 5-year average (16.0) and above the 10-year average (14.3).

My what a correction will do to the overvaluation argument.


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The Political Scene

The vote was there, the vote wasn’t there, the government shut down for a while then reopened before I had my morning coffee on Friday. Happy days are here again.

Notably for investors, the bill also extended the debt ceiling until March 2019 and funds federal agencies until March 23, 2018, giving Congress additional time to develop a spending bill that will last through September 30, 2018, the end of the federal government’s fiscal year.

This will now allow investors to be totally obsessed with every 0.01% move on the 10 year treasury note. (sarcasm intended)

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The Fed

In my view, way too much concern on how the new Fed chair Jerome Powell will approach the interest rate situation. Some of that concern will be addressed when he steps in front of Congress and gives testimony on February 28th.

I cannot see any change from the data dependent stance that has been in place since the Bernanke era. I do see rates approaching 3%, but they are rising for the RIGHT reason, an improving economy. I might add we saw a 3% 10 year back in 2013 and early 2014, GDP in the 4th quarter of 2013 was 2.6% and stocks rose all through this period in time.

Rates rocketing overnight? Could that really happen? Maybe, BUT, what happens when there is fear? Investors flock to treasures. What happens when they buy into the safety of treasuries? The yield on the notes is pressured down. Basically creating an equalizing effect. Rates should rise gradually over time in a backdrop of an improving economy.

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Sentiment

My instincts told me the spike in bullish sentiment that had some concerned would be temporary. The last few weeks that bullish sentiment has been in retreat. Based on the weekly survey from AAII, bullish sentiment declined from 44.8% down to 37% for the fourth weekly decline in the last five. At the start of the year, bullish sentiment spiked up to just under 60%.

Cross a euphoric environment off of your worry list. Anyone that just jumped on board the stock market got a quick lesson in stock market psychology.


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Crude Oil

The weekly inventory report was benign. Inventories were reported with a slight build this week, adding 1.9 million barrels, that was smaller than expected. Gasoline inventories also increased by 3.4 million barrels. The price of crude sold off with stocks and like the S&P gave back all of its 2018 gains. WTI closed out the week at $59.20, down $6.22 or about 10% from the prior week close.

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The Technical Picture

In terms of breadth, it has dropped off a cliff along with the major indices. Following last Monday’s decline, the percentage of S&P 500 Industry Groups trading above their 50 day MA dropped to 4.2% from a level of 91.7% just two weeks earlier.

Source: Bespoke

These types of sharp declines in breadth have been uncommon over the last 28 years. Bespoke Investment Group reports that following the nine prior periods where we saw similar sharp declines in group breadth over a two-week period, the S&P 500 saw much better than average returns going forward. Some say it presents a washout scenario.

Source: Bespoke

The S&P 500’s performance following each of these “washouts” is positive. One week, and one month later, the S&P 500 averaged a gain of right around 3%, although the median one month return was even stronger at 5.1%. The real impressive returns, however, came in the following three and six months. That plays into my theory that we will now see a period of consolidation before any real gains are achieved. Three months later, the S&P 500 was positive nine out of nine times for an average gain of 8.3% (median: +6.4%), and six months later, it was also positive every time averaging a gain of 13.6% (median: 13.7%).

In the year following each of these periods, the S&P 500 averaged a gain of 19.8% (median: 21.5%). The only time the S&P 500 was down a year later was in the period following the March 5th, 2007 event. In that year, the S&P 500 peaked in October, and the Financial Crisis began to unfold. Notwithstanding that one outlier, similar washouts in industry group breadth over a two-week period have historically been followed by strong gains.

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All short term support levels were taken out this week. Plenty of technical damage to the short term charts. The daily chart of the S&P shows the quick decline, then a rally that failed to recapture the 50 day moving average (blue Line). Note prior support now becomes resistance. That was followed by a selling binge that saw the intraday low of 2593 taken out on Thursday, and selling pressure continued on Friday. That dropped the S&P below its 200 day moving average. Perhaps a reversal occurred on Friday, the S&P fell to new lows, then rallied above the prior day close.

Chart courtesy of FreeStockCharts.com

I do not believe we will see any type of “V” recovery in prices. The mindset of investors has decidedly changed, they are obsessed with interest rates now. Bullish Investors now need to reset their expectations for the short term. A period of consolidation while the market tries to carve out a bottom. How long this lasts is anyone’s guess. My thoughts are that the S&P trades within this wide range, from 2500+ to the old high, as it builds a base.

The new line in the sand is the intraday low on Friday, S&P 2535. If that gets taken out, my downside target moves to S&P 2490. Resistance is the old support at the 100 day MA, S&P 2639.

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Individual Stocks and Sectors


Last week the market began to show its first signs of mean reversion, and this week we’ve seen a full blown pullback that quickly erased a month’s worth of gains and wiped out all instances of overbought levels. As long as the long term uptrend remains intact, this correction was needed will prove to be a good thing.

Source: Bespoke

So with the new backdrop of a sideways market anticipated, it will be a time to get positioned for the next leg higher, but depending on YOUR situation, there is no rush, be patient, pick your spots.

So while we have a consolidation phase now, there is no need to abandon the three sectors that will be the beneficiaries of improved earnings, Technology, Materials and Healthcare. Six weeks into the year isn’t time to start making any drastic changes to strategy with the bull market backdrop still in place.

Selecting stocks which have put forth great earnings reports and raised guidance that are now being tossed aside, is the strategy to follow. Step back, take a deep breath, and realize that other than a change in the short term mindset of investors, these solid fundamental stories have not changed. In fact in many cases, they have IMPROVED.

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A while ago I mentioned that we were transitioning from a liquidity driven market to an earnings driven one. That has indeed happened, and it looks to continue. Earnings growth was the primary driver behind the equity resurgence in 2017 following a 3 year lull. I expect the same for 2018. This bodes well for the big earnings growth sectors like Health Care and Technology.

Sorry, you won’t find me in the camp that says we are in a runaway growth situation at this point in time that brings runaway interest rates with it. In fact I believe that is absurd thinking today. What we will probably see is a moderate growth trajectory for GDP and yes, inflation as well. The tax bill is focused on getting businesses to invest in the economy. Although expected to deliver strong results over time, these investments likely will take time to be reflected in actual economic output. As a result, a 4% or higher GDP or inflation level is not likely tomorrow. I still expect earnings quality to drive equities higher, benefiting growth stocks.

OK, that’s great but this new market mindset will not go away tomorrow. It is important to remind ourselves. We had an overheated market that met up with a change in investors view of the underlying economy. The result is irrationality. In a normal situation, all of us could have expected a simple reversion to the mean. Well we did get that, but it also came with a stick of dynamite, called investors emotions. When emotions enter the picture, there is no telling what may occur, and how long irrationality lasts.


The earnings picture could surely stall any real downside, the give and take we can expect now will come from the emotional reactions on the interest rate scene, and any other headline that spooks nervous investors. The secular trend remains powerfully bullish, all of us need to be reminded of that. Ask yourself. Ever see a bear market start with earnings growing at double digits? Ever see a recession or a bear market start at the beginning of a rate hike cycle? Is the yield curve inverted?

In my view anyone selling now on what they fear regarding interest rates is making a mistake. They aren’t looking at ALL of the facts. Sure there was a need for a correction, stocks got overbought. Now the pendulum has swung and the sentiment might lead to an overshoot on the downside as well. Emotion is a powerful thing, and when it enters the picture, common sense is tossed aside. It’s best to have an open mind, so we keep ALL views on the table. It is a time to watch, pick our spots, but rest assured, I am not selling stocks now.

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to all of the readers that contribute to this forum to make these articles a better experience for all.

Best of Luck to All !

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Stella Densmore