Wednesday, July 18 , 2018, 8:10 am | Overcast 65º


Craig Allen: Start of ‘The’ Correction, or (Another) Buying Opportunity in Stocks?

This past week’s stock market performance shocked many investors who have grown accustomed to steady gains for stocks — week in, week out.

The combined drop of nearly 400 points for the Dow Jones Industrial Average over the past two trading sessions (July 31-Aug. 1) led the stock market to its worst weekly performance since January.

This result prompted some investors to ask: Is this the start of a major correction, or just another in the long line of buying opportunities?

Investors have certainly been rewarded over the past two years plus when they have assumed the risk of stepping into stocks each time we have seen more than a 1 percent correction in the overall stock market. Stocks have not suffered a 10 percent or greater correction for well more than two years. This trend has fostered an extreme, and some would say dangerous, level of complacency with investors.

As we have traveled deeper into the bull market, the “big money” institutional investors running mutual funds, hedge funds, pension plans, private equity funds and the like, have been pulling money out of stocks, while the smaller investor has continued to buy.

The most recent survey of advisors shows a bullish percentage of 56 percent. Typically, a high reading on this survey is an indication that a correction is more likely, if other factors are also present, such as divergences among the market leadership (we are definitely seeing this today), and the ratio of new highs to new lows goes down, even as stock continue to make new highs.

Small Caps in a RUT

The Russell 2000 (symbol RUT) is down significantly from where it began 2014, closing Friday at 1,115, down 50 points year-to-date, or 4.2 percent. More than $6 billion flowed out of high-yield (junk) bonds in July alone. These two segments of the market tend to be more sensitive to market directional changes, and are leading indicators (they more first) when there is a major change in market direction.

Certainly there were drivers that could help explain why last week’s market performance was poor: Argentina officially defaulted on some of its bonds after negotiations with some hold-out hedge funds collapsed, prompting Standard & Poor’s to downgrade these bonds to default status; tensions rose significantly in the Russia/Ukraine situation after new sanctions were announced; tensions between Israel and Palestine spiked; the Fed meeting failed to give us any clear direction on the timing of interest rate increases; and the employment data were a bit disappointing (although bad news is good news — sort of — when it comes to weaker employment data because it gives the Fed more flexibility with regard to the timing of future rate increases).

But none of this can really effectively explain why stocks got hit so hard Thursday and Friday. What can explain this market action is the fact that stocks are grossly overvalued by any measure. When stocks are overvalued, as I have written in several previous columns, anything, even something relatively insignificant, can trigger a market sell-off.

That is exactly what we are seeing with the current market environment — stocks are very expensive, so the least little thing can spark selling as nervous investors run for the exits to try and lock in the gains they have made, and avoid losing those gains.

Another key fact about the current stock market level (bubble) is that we have a significant percentage of investors holding stocks right now who are not really stock investors. Those investors who would normally buy bonds, real estate and other investments are holding stocks because stocks are the only game in town.

These investors simply cannot generate the returns they need/expect from other asset classes (like bonds), due to factors such as historically low interest rates, the difficulty in getting loans (for real estate), etc. As a result, these investors are reluctant stock investors who really are not suitable to own stocks, and they will be the first to jump ship if there is a slightest sign of a major correction.

As we enter August, and a new month of trading for stocks, it will be interesting to see if investors once again see the recent slide in stocks as a buying opportunity. We have seen 27 new highs set by the S&P 500 so far in 2014. Will we see number 28?

It is possible, but each time the market pushes up to new highs, valuations get stretched even further, placing the market in an even higher degree of peril. The healthiest thing for the market right now would be for it to have a 10 percent to 15 percent correction. Were this to occur, most would feel that valuations were once again attractive enough to invest, and we could see a further advance, possibly to new, all-time highs.

If we do not see a correction in the very near-term, my feeling is that in the September to October time frame, stocks will experience a much larger correction or crash, with at least a 20 percent drop. In fact, 20 percent could look like the market getting off lightly, given some of the historical drops we have seen during the September/October time-period historically.

This week’s action will be telling — if we can stabilize early this week, stocks have a good chance of a rally back to or near all-time highs. If stocks continue to slide, I would expect panic to set in, and to see a sizable drop for stocks.

Craig Allen, CFA, CFP, CIMA, is president of Allen Wealth Management and founder of Dump That Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here to read previous columns or follow him on Twitter: @MPAMCraig. The opinions expressed are his own.

Support Noozhawk Today

You are an important ally in our mission to deliver clear, objective, high-quality professional news reporting for Santa Barbara, Goleta and the rest of Santa Barbara County. Join the Hawks Club today to help keep Noozhawk soaring.

We offer four membership levels: $5 a month, $10 a month, $25 a month or $1 a week. Payments can be made through Stripe below, or click here for information on recurring credit-card payments and a mailing address for checks.

Thank you for your vital support.

Become a Noozhawk Supporter

First name
Last name
Enter your email
Select your membership level

Payment Information

You are purchasing:

Payment Method

Pay by Credit Card:

Mastercard, Visa, American Express, Discover
One click only, please!

Pay with Apple Pay or Google Pay:

Noozhawk partners with Stripe to provide secure invoicing and payments processing.

  • Ask
  • Vote
  • Investigate
  • Answer

Noozhawk Asks: What’s Your Question?

Welcome to Noozhawk Asks, a new feature in which you ask the questions, you help decide what Noozhawk investigates, and you work with us to find the answers.

Here’s how it works: You share your questions with us in the nearby box. In some cases, we may work with you to find the answers. In others, we may ask you to vote on your top choices to help us narrow the scope. And we’ll be regularly asking you for your feedback on a specific issue or topic.

We also expect to work together with the reader who asked the winning questions to find the answer together. Noozhawk’s objective is to come at questions from a place of curiosity and openness, and we believe a transparent collaboration is the key to achieve it.

The results of our investigation will be published here in this Noozhawk Asks section. Once or twice a month, we plan to do a review of what was asked and answered.

Thanks for asking!

Click Here to Get Started >

Reader Comments

Noozhawk is no longer accepting reader comments on our articles. Click here for the announcement. Readers are instead invited to submit letters to the editor by emailing them to [email protected]. Please provide your full name and community, as well as contact information for verification purposes only.

Daily Noozhawk

Subscribe to Noozhawk's A.M. Report, our free e-Bulletin sent out every day at 4:15 a.m. with Noozhawk's top stories, hand-picked by the editors.

Sign Up Now >