A completed correction in stocks that has refreshed a bull market looks and acts just like the opening act of a bear market, in which powerful rallies are beguiling traps and the overshoots happen to the downside. This is why anyone trying to characterize the recent oppressive sell-down in the indexes — and the outright dismantling of many sectors — should heed Federal Reserve Chair Jay Powell's remark last week that one should embrace "humility" in handicapping complex phenomena such as inflation or market cycles. With that disclaimer out there, it's fair to say the broad retreat in share prices leading to last week's mercurial thrashing across wide daily ranges and strong tension-release rally on Friday fit reasonably well the profile of a proper correction process noisily running its course. A week ago, this column offered this assessment of the market's field position : "In the short-term, the elements of a decent trading low are starting to arrange themselves…Traders itchy to catch a relief rally might be hoping for another emotional flush in coming days." This is pretty much how last week played out, a steep slide in the indexes Monday that generate intense trading volumes, historic levels of hedging volumes in the options market and deeper oversold conditions, culminating in the S & P 500 hitting its lowest point since the summer, down 12% from its peak three weeks earlier. The rest of the week saw daily rally attempts fail as the tape churned uneasily, but the Monday lows were never revisited, and then Friday's late upside burst took the index slightly positive on the week. Impressive, for sure, though of course not decisive. Such things are only verifiable with more than a day's hindsight. Sure, the mega-caps led by Apple did plenty of the work, along with reflex bounces in the most-ravaged high-volatility stocks augmented by short-covering. Nothing unusual there for a relief rally, which is always what gets a recovery started. Driving the action A couple of mechanical aids to the market's supply-demand interplay were likely also at work. The deep underperformance of stocks versus bonds in January set up a likely rebalancing flow into stocks by asset-allocation funds, in a month when retail retirement-fund infusions are a typical feature as well. And at Thursday's close, the 18 th trading day of the year, one of the strongest brief seasonal stretches of the year began, lasting four or five sessions and into early February. McMillan Analysis calculates that this period has been higher for the S & P 28 of the past 36 years with an average return far better than average over such a span. Meantime, the pullback made progress in the areas that a correction is meant to address: Relieving valuation excesses, culling the equity ranks by punishing lower-quality names and putting a healthy scare into investors to reset expectations. Valuations have rapidly become less foamy, even if the vast majority of market cap is not outright cheap, particularly given decelerating growth, tighter Fed and margin pressures in plenty of areas. The S & P 500 is down near 19-times the next 12 months' expected earnings, around its five-year average and down from 21.5 on Thanksgiving. Apple and Visa rallied 7% and 10%, respectively, on Friday after reporting results. The numbers were sturdy, for sure, but the fact that Apple was down to a 27 multiple from 30 several months ago and Visa had sunk to 27 from 36 last summer also explains the bounces. The S & P Small-Cap 600 is just above 13-times forward profits, and the cheapest it's been relative to the S & P 500 in more than 20 years. None of this is useful in drawing a line under the market or triggering a quick rebound, but a less-expensive market is a lower-risk and higher-return one for those buying or holding for longer periods. As for the scare, consider it delivered. Last week the American Association of Individual Investors survey had bears outnumbering bulls on stocks over the next six months by the most since the 2020 Covid plunge and before that in 2013. Again, not a perfect contrarian signal for immediate upside in the market. And Bank of America's Michael Hartnett points out that retail investors' equity exposure overall remains high and net inflows have continued into equity funds, belying any claim that capitulation has been thorough. Still, it's rare that the market goes down much or stays down long right after this type of AAII reading, and measures of hedge-fund positioning and margin deleveraging generally agree. In a true bear market, the "normal" ranges for sentiment and positioning reset lower, though some historical work shows pessimism now well exceeds where it "should" be based on the magnitude of the index losses so far. What's next? The twitchy switchbacks, fleeting rallies and frequent air pockets featured in last week's trading sap traders' conviction and look to plenty of investors like an unhealthy rhythm. Bespoke Investment Group on Friday noted the S & P 500 had gone four straight days with moves of at least 0.75% from the opening level in both directions. Such a four-day fibrillation had happened only eight times before in 24 years. Following the prior weeks, the market tended to remain treacherous the next week but was higher a year later each time — albeit in two cases with brutal bear-market drawdowns along the way. The intense liquidation across most of the growth-stock and recent-IPO areas have certainly qualified as a brutal culling of the flock. SentimenTrader.com shares this look at the number of Nasdaq-listed securities that have been cut in half, the recent total exceeded only in the post-2000 tech meltdown and the Global Financial Crisis – both times when the S & P 500 itself was cut in half from high to low. The standard financial-advisor line at times like this is that the market ultimately will move with the economy, that bear markets without an accompanying recession are fairly rare. And when they do occur, they aren't as deep or long-lasting. And the New York Fed's recession probability model – based on the shape of the Treasury yield curve – shows only an 8% chance of a recession by December 2022. Comforting, for sure, though as noted deeper, grinding corrections have happened absent a contracting economy. The current phase somewhat resembles the December 2015-Februaryt 2016 period, when the Fed pushed through its first rate hike of a cycle into a global economic slowdown and industrial retrenchment. The S & P fell 12% into a January low, bounced, then rolled to a deeper low some 15% below its prior peak, with far worse damage to the typical stock. Yet back then, credit markets were in distress, while today they have modestly weakened but only back toward the relatively benign levels seen last fall. The U.S. economy was near stall speed and disinflation persistent. Today we saw 6.9% real GDP last quarter and inflation is high and needs taming. Is it a plus that Wall Street got a hawkish surprise from Powell on Wednesday, and immediately began talking itself into between five and seven rate hikes this year, yet stocks held above Monday's low and found late-week traction? The case can surely be made, in service of the quite-plausible yet unprovable idea that the correction has achieved much of its purgative work, even as it can always do more.
A trader works, as Federal Reserve Chair Jerome Powell is seen delivering remarks on a screen, on the floor of the New York Stock Exchange (NYSE), January 26, 2022.
Brendan McDermid | Reuters
A completed correction in stocks that has refreshed a bull market looks and acts just like the opening act of a bear market, in which powerful rallies are beguiling traps and the overshoots happen to the downside.