Correction Begins in Earnest

After making an intermediate high on January 26th, the markets’ corrective process has now been underway for more than six weeks. Although this was not the longest rally without a pullback, it was certainly looking long in the tooth.

Much of this consolidation has been an orderly, light volume affair – complacent, even. This week, however, the lackadaisical tone changed as the sellers became more insistent. Trading volumes have risen every day this week. Defensive sectors (Oil Services, Insurance and Utilities), attracted money from the tech and telecom sectors. That has since changed, as money is now leaving equity markets for safer havens. What was formerly a mere rotation between sectors has now shifted to a minor exodus.

Several historical patterns we watch are suggesting that this pullback is not the beginning of the end, but merely an overdue consolidation, likely to run several weeks or months:

First is the 5% pullback. On average, rallies hit their first 5% pullback on the Dow and SPX at roughly the 60% mark (i.e., the rally has achieved 60% of its gains, and has another 40% to go). That suggests to us more upside remains, albeit from likely lower levels. We also believe that it is less likely to be as “fast and furious” as 2003’s move. Investors, in our opinion, will need to be more selective when it comes to sector and corporate quality.

Secondly, we note a recent study by Tony Dwyer regarding S&P500 and Dow annual series histories. Each time a year of net gains follows a year of net losses, the subsequent 3rd year in the series has mostly been positive. On the Dow, gains occurred 85% of the time in the 3rd year, going back to 1914. The S&P500, with a much shorter history, has never had a negative 3rd year in that consecutive “Negative-Positive-Negative” cycle. This is noteworthy, although not determinative. History may not repeat, but it does rhyme.

In 6 of 8 prior “2nd Year Rallies” (the 3rd year of this cycle), markets experienced meaningful declines in the 1st quarter of the year. Declines came after an average gain of 3% in early part of quarter. The average drop from peak to low was 5.3%, while the declines lasted from 1 to 7 weeks.

The sell off is now producing enough fear that several contrary indicators (i.e., Arms Index) we track suggest we are due for a short-lived (but only short-lived) bounce. The number of stocks trading below their 50 day moving average is at its highest level since this rally began. We suspect the sell off has not yet run its full course. Our previous support levels of 1875 on the Nasdaq and 9900 on the Dow remain in effect.