Friday’s 2 percent fall for the three major U.S. indices was followed by significant declines in Asian markets, with Japan and Hong Kong down well more than 2 percent early in Monday’s trading session.
The Standard & Poor’s 500 lost 2.65 percent last week and is down 3.1 percent year-to-date. The Dow Jones Industrial Average lost 3.5 percent last week and is down 4.2 percent year-to-date. The Nasdaq Composite has performed slightly better, although it lost 1.7 percent last week and is off 1.2 percent year-to-date.
Does Friday’s decline, the worst for the Dow since June 20, represent an attractive buying opportunity, or is this the start of a major correction phase for U.S. stocks?
There is no doubt that last week’s stock performance shook investor confidence. The VIX (volatility) index, also known affectionately as the fear index, shot up 9 percent on Friday.
Argentina’s surprising devaluation of its peso — 11 percent over the Wednesday-Thursday period — was at the core of the slide, which began with heavy selling in emerging market securities.
While this devaluation was certainly a trigger, large sell-offs usually occur when market valuations are expensive, as is certainly the case at present. When investors have experienced sizable gains, as we did in 2013 with the 30 percent gain for the S&P 500, and again when valuations are high, any sign of trouble will spark selling pressure.
Throughout the bull market rally in U.S. stocks, most single-day sell-offs have been followed by rebounds as investors perceive the fall in stock prices as a buying opportunity. Will we see the same bounce now? Not necessarily.
What could make things different this time is a combination of several key factors. Valuations are a result of revenues and earnings. Revenues have consistently disappointed so far this earnings season, which has been occurring over the past two weeks or so. This was particularly prominent in large bank and financial institution earnings reports. The willingness of banks to lend money is essential to a healthy economic recovery. If banks are not seeing revenue growth, they are more likely to tighten their purse strings, constricting the availability of credit.
The Fed will meet Tuesday and Wednesday to decide if it will reduce stimulus further, after January’s $10 billion reduction in bond buying, to $75 billion from $85 billion. Most economists believe the Fed will taper by another $10 billion in February. The upcoming meeting will provide the answer to this highly important and anticipated question.
With tax time rapidly approaching, last week’s poor stock performance could motivate many to take profits to raise cash in order to pay their taxes. Certainly some of the selling last week was the result of profit-taking, with investors scrambling to lock in their positive performance from last year.
We have strong evidence of profit-taking since the four-worst performing sectors on the S&P 500 for 2014 are the same sectors that hit 52-week highs on Dec. 31: The materials sector is down 5.1 percent, consumer discretionary stocks are down 5 percent, and industrials and energy stocks have each shed 4.9 percent. If profit-taking continues this week, this selling momentum could send markets into a correction phase.
This week will be the busiest for earnings reports, with a third of Dow components and a quarter of the S&P 500 companies reporting. DJIA-member companies reporting this week include Caterpillar Inc., DuPont, Pfizer, AT&T, Boeing, 3M, ExxonMobil, Visa Inc. and Chevron.
We will also see some of the largest technology companies reporting this week, including Apple, which reports Monday after the market closes. Some of the other major technology players reporting this week include Yahoo!, Facebook, Qualcomm and Google Inc.
Markets will also need to digest a large number of key economic reports this week, including December new home sales data on Monday, durable goods orders and the consumer confidence index on Tuesday, and fourth-quarter GDP data and jobless claims on Thursday. Friday’s a big day with December consumer spending figures, January Chicago Purchasing Managers Index and the University of Michigan consumer sentiment index.
With all of this new information swirling around in the heads of investors who are already nervous after Friday’s sell-off, it would likely take a perfect storm of positive results from all of these sources of information to stabilize markets. This seems highly unlikely to me.
Possibly the most important issue investors will need to focus on will be any additional devaluations or other currency problems out of emerging market countries. Historically, countries do not devalue in isolation, especially in Latin America. It would not be surprising to see a contagion spread across Latin America stemming from Argentina’s currency problems. The ripple effect from multiple currency devaluations could spread across the globe rapidly, driving a flight to safety — selling in stocks and buying in bonds.
A 10 percent correction from the recent highs would bring the S&P 500 down to around 1,660, while a 15 percent drop would place the index at about 1,570. A 20 percent decline would see the S&P 500 at around 1,500. If stocks can mount a rally Monday, investors should gain confidence and we may see stocks run right back up to the highs or beyond. However, if we see follow-through selling today, this will likely be the beginning of a sizable correction of at least 10 percent.