With the S&P 500 having hit the -10% mark last week, there can be little argument that the stock market is officially in correction mode. As such, the question of the day is whether the current corrective phase is about over - or - will morph into a bear market.
In my experience, the best way to answer is to start with another question. Have the expectations for any of the key market drivers (the economy, inflation, rates, the Fed, and earnings) changed to a significant degree?
As I wrote last time, stocks were indeed overvalued and due for a pullback as the calendar flipped to 2025. And with all the tariffs and retaliations, it isn’t surprising to see analysts reworking their expectations for earnings, inflation, the economy, and the stock market. After all, a tariff increases the cost of goods and somebody, somewhere has to pay that cost. The question is whether it is the company making the product (which affects earnings), the country exporting/importing the product (which affects GDP), or the consumer paying for the product (which affects inflation and the consumer’s ability to spend).
Making Adjustments
Putting pencil to paper on the subject, Wall Street analysts have been busy adjusting their estimates for all of the above. On the earnings front, instead of the 16.3% increase in the S&P’s 2025 consensus earnings per share (EPS) that was anticipated at the beginning of the year, the consensus for EPS growth this year is now more like 14%.
From a big-picture standpoint then, it makes sense for stocks to have pulled back a bit - because earnings are going to be less than expected. The big question, of course, is how much lower are earnings going to be?
The Reasons for the Decline
The key is this is where fear and uncertainty come in. From my seat, the market has been declining in violent fashion for two primary reasons. First, there is the "fear" of what might happen to the economy, inflation, and earnings. In short, traders have been selling first and asking/answering questions later.
The second reason stocks have been thrashed so quickly is an oldie, but a goodie - the unwinding of positions that had become excessive and overdone.
According to Goldman Sachs, hedge funds were more leveraged long in US equities than at any point in the last five years. Goldman tells us that CTAs were levered 2.9 times their books - so basically triple leveraged. Putting these positions on obviously helped push stocks ever higher in 2024. As I’ve stated, my take is traders were essentially "pulling forward" gains from the strong earnings that were to come in 2025.
But then things changed. The White House started implementing tariffs. To which the affected countries retaliated with tariffs of their own. Which, of course, were followed by threats of even more tariffs. Rinse and repeat. And before too long, traders began to fret that things would get out of hand. Which, of course, would definitely impact the economy, inflation, and earnings - and not in a good way!
So, with the hedgie crowd levered up to their eyeballs, I likened what happened next to someone yelling, "everybody out of the pool!" My take is traders basically all did the same thing at exactly the same time. I.E. They sold positions to reduce their risky levered positions. And they likely kept selling, regardless of the news (better than expected CPI/PPI, Ukraine ceasefire, econ data, gov’t debt/shutdown avoidance) until the uber-levered positions were gone.
From my perch, this explains why the market has been SO violent to the downside - a whole bunch of aggressive sellers all looking to liquidate positions NOW. And what do buyers do in such a market? Oh, that’s right, nothing. Nope, they sit on their hands and wait for the violence to subside.
Where To From Here?
The good news here is we’ve seen this movie before. So many times, in fact, that most of the experienced investors I know have developed a Panic Playbook. In short, we know from history how the game will likely play out - in general terms, of course.
The first step in any panic is the initial emotional plunge. Obviously, we can’t be sure that this phase is over yet. But, with the market now deeply oversold and sentiment measures registering extremely negative readings, a bounce is to be expected. And it is the veracity of this bounce that is usually a "tell" as to what is likely to happen next.
A quality bounce will last more than a couple days and impress on the way up. This is the first indication that the panic cycle may be waning. However, if the bounce winds up being feeble, stocks tend to continue lower for a spell. An example here would be Wednesday’s pathetic effort that was thwarted by yet another tariff tape bomb.
From there, history suggests that the market will either "V-Bottom" (if the reason for the decline looks to be resolved) or experience a retest of the lows to be followed by a bottoming phase as the news fluctuates.
After that, we will be looking for what is called a "breadth thrust" where buyers overtake the market and produce a surge accompanied by impressive breadth (Up/Down Volume, Advances vs Declines, etc). The breadth thrust signals are important because historically they have tended to produce "all clear" signals for the next year.
Summing Up
To sum up the situation, I’m of the mind that we’ve got a bad news panic on our hands that has been exacerbated by hedge funds unwinding excessively levered positions.
From a macro perspective, I don’t see any signs of recession (yet?), the economy is still in good shape, and earnings are expected to move to record highs this year. So, unless something changes in a meaningful way, my thinking is it is probably best to remain calm and stay in your invested seats. But, of course, if things change, we will make adjustments in an effort to stay in tune with the major market cycle.
Thought for the Day:
If you don’t know where you are going, you might wind up someplace else. -Yogi Berra
Wishing you green screens and all the best for a great day,
Disclosures: At the time of publication, Mr. Moenning held long positions in the following securities mentioned: None - Note that positions may change at any time.