The September market swoon accomplished most of what corrections are supposed to do

People walk along Wall Street in lower Manhattan on September 21, 2020 in New York City.
Spencer Platt | Getty Images

The September market correction has done much of the work set out before it.

The four-week slide took the S&P 500 down 10% at last week's low, cost the Nasdaq Composite as much as 14%, relieved grossly overextended conditions in mega-cap tech shares, punctured investor overconfidence and showed newcomers to trading that stocks don't always go up.

So far, so good. (Or bad, depending on one's risk exposures a month ago.)

If all that was needed after the racy summer rally was to unwind extreme chart readings and sow some self-doubt in bullish investors, it's not clear much more of a decline is necessary.

Aside from skimming 10% from the S&P 500 and more from the biggest and most stretched growth stocks, the retreat also took the market back in time. At last week's lows near 3200 — approached a few separate times without being breached — the index returned to where it traded June 8, the peak of reopening optimism; this was also its year-end 2019 level.

By Friday, only a quarter of S&P 500 stocks were above their 50-day average, right at the border of a common "oversold" reading. More than a third of the stocks in the index are at least 20% off their high.

No magic buy triggers there, but moving in the direction of a better risk/reward setup. If the main complaint through the summer was stocks had raced ahead too far too soon, this reset offers an answer to it.

These are hints that the pullback is maturing, even if it isn't quite the case that the market is truly washed out or investor sentiment decisively pessimistic.

Investor sentiment turned quickly

The National Association of Active Investment Managers equity-exposure index has dropped from a multi-year high above 100 (meaning leveraged long stocks) on Aug. 26 down into the 50s last week, a roughly neutral reading.

Large speculators in Nasdaq index futures are now aggressively short, which has bullish mean-reversion implications. Last week, more than $25 billion flowed out of equity mutual funds and ETFs, according to Bank of America, the largest withdrawal since December 2018 – more a contrarian positive for stocks than a concern about demand for them.

Citigroup strategist Tobias Levkovich reported Friday that a survey of 80 institutional investor clients showed an average year-end S&P 500 target if 3350, up less than 2% and a level the market traded at the week before last. This supports the idea that expectations are muted.

The weakness helpfully broadened last week beyond the Nasdaq giants and overheated speculative tech plays — in fact, the Nasdaq nicely outperformed last week after leading the tape up in August and down in the first half of September. This is probably another plus.

Two weeks ago here, I asked, "Do professional investors who've been complaining for months about the narrowness of the market and the need for a pullback seem a bit too satisfied and comfortable with the way this market break has played out? Do folks need to be more scared before a reliable low takes hold?" This has happened, to a degree.

Sign of bigger problems?

Again, this is all reassuring for bullish investors if all this has been is an equity-market attitude adjustment and clean-up of crowded positioning.

Barry Knapp of Ironsides Macroeconomics, who was looking for the market to backslide starting in late summer, last week said, "Like many equity market corrections, what began as a positioning rationalization evolved into a fundamental deterioration narrative. The Nasdaq correction morphed into a third pandemic wave, potential European lockdowns, risk of election chaos and a stalling and reversal of the economic recovery."

He disagrees, seeing the manufacturing, housing and corporate-profit recoveries intact, and the equity setup more stable, arguing that "the irrational exuberance positioning in the winner-take-most technology, consumer discretionary and communication services companies is now balanced and…some investors are leaning short."

For most of the month, credit markets remained firm and Treasury yields almost static, which argued against a fresh buildup of economic stress reflected in the equity weakness. That said, market-based inflation expectations have slipped, the dollar rallied, which can be read as investor doubt in the Federal Reserve's ability to get inflation to its new, higher target and drive faster nominal growth.

And corporate bonds did weaken a bit last week, with many eyes on the flagging prices of the iShares iBoxx High Yield Corporate Bond (HYG) ETF as a foreboding omen. It certainly bears watching. Though Jeff deGraaf of Renaissance Macro Research points out this is common near the latter part of a stock correction, and in fact when the S&P starts outperforming HYG, it often means the equity uptrend is resuming.

Is it over?

The S&P 500 was down four weeks straight, and of the last eight such streaks, seven gave way to a positive week for the index the following week. Seasonal patterns start to improve through the end of September and into early October. Yes, the Street is clenching up tightly about a possibly suspenseful election, but on the bright side, the Street is already tightly clenched over it. The tendency for a fourth-quarter rally is, if anything, a bit stronger in presidential election years, for what that's worth.

Reassuring, perhaps, though it should be said the market didn't exactly prove all that much with Friday's 1.6% S&P rally, which found traction near that minus-10% threshold but nonetheless didn't even reach Wednesday's high by the close. The charts of the mega-cap stocks atop the index look quite disordered, with sharp peaks and broken short-term uptrends, and need to be rebuilt. There is no nearby valuation support for the index to speak of, even as earnings forecasts continue to firm up.

So further chop and mutual frustration among bulls and bears should surprise nobody. That's how corrections tend to feel, even the benign, healthy ones.