The markets, which had been gently inching towards correction territory, got pushed over the threshold on the news of Russia invading Ukraine. The obvious reaction to this unfortunate news hit the markets overnight.
It was a true risk-off environment with government bonds moving higher, the U.S. dollar rising along with other “safe-haven” currencies, gold up 3%, and of course equities lower. The Bloomberg World index, which covers 85% of all equities, was pushed below the 10% correction threshold for the first time since the pandemic-induced market drop.
But hold on, as the day progressed, the selloff faded, and markets recovered, once again reminding investors that even if you get the macro call right (i.e., Russia invades), equally important is correctly guessing how the market will react. You must get both parts right to turn a profit in the short term—an elusive goal and perhaps why the career length of day traders tends to be short.
Corrections are normal
Our memories suffer from a few biases—notably that recent events tend to carry a greater influence on our worldview. For those technicians, think of it like this: instead of our memories being a simple moving average, they’re more like an exponential moving average. Or for normal humans, think of how you remember the last month of your life with greater detail than what happened in the same month a year ago.
This greater emphasis on recent history has us focusing more on the last 20 months, which from a market perspective included limited pullbacks, low volatility, and outsized gains, making this recent bout of weakness likely seem harsher. But the fact is: corrections are normal market events.
Over the past 70 years, there have been roughly 40 corrections for the S&P 500. Well, that is simple math: a correction every 1.75 years. Since we hadn’t experienced a correction since the drop in February and March of 2020, almost two years ago, the markets have actually been doing remarkable well. Of course, 1.75 is an average, so don’t go marking your calendar for the next correction in November 2023. Perhaps the markets were simply due.
So, is this a buying opportunity or harbinger?
There is a simple rule for corrections – if there isn’t a recession around the corner, they are all buying opportunities. If there is a recession coming, all bets are off. This naturally leads to the next question: is there a recession on the horizon? The good news here is a very confident “not likely.”
The global economy is growing at about a 4-5% pace, the U.S. economy even faster. This Russia mess may slow create a bit of a bump but with such economic momentum, recession risk is very low. The chart below shows a couple Fed recession probabilities that are very low. Add to this our market cycle framework that incorporates over 30 indicators, we concur with the Fed banks.
Not so fast. While some of the correction buy signals have flashed green, others have not. One of our historical favourites has been the American Association of Individual Investor sentiment survey. When investors are bearish, this had signalled market bottoms. We find using a four-week average sentiment of bulls minus bears provides a more reliable signal. Over the past 20 years, when at -20, the forward return for the S&P 500 has been rather strong, with the exception of 2008, which again leads us back to whether there is a recession looming or not.
However, survey data has been rather odd over the past few quarters. For this survey, investors turned pretty bearish even before the market weakness set in. That is odd. Consumer confidence survey data has been particularly weak as well, which doesn’t add up with employment, wage, and wealth trends. Still, this is a compelling data point to be bullish from here.
Less compelling, the VIX moved higher but never really spiked. Spreads have moved higher but not materially, compared with 2018. The bond/equity correlation as well, which during risk-off markets tends to become strongly negative, has only marginally moved in that direction. Market breadth has fallen but not to normal correction trough levels.
A correction does not require all these signals before a bottom is put in, but it would be more reassuring if a few more of them were giving the buy signal. Then again, actively buying during periods of market weakness is never easy and often feels wrong.
The market weakness so far this year has been very concentrated, in the growth and size factors, and has only spread partially to the rest of the market. This is evident in the S&P 500 growth index being down 14% this year, compared with the S&P 500 value index being down less than 4%, or the value-tilted TSX being down only 1.5%. International markets are down more, with a market’s proximity to Ukraine acting as a current factor.
Markets enjoyed a few years of performance well above trend but have a lot to digest this year. Central banks are pivoting the stimulus machine. Inflation remains a risk. And behaviours are changing: going back from durable goods to services (this it is starting to show up in select company earnings as well).
This is a correction but there just don’t seem to be enough signals to jump in with both feet. Maybe just a toe or two in some parts of the market.
— Craig Basinger is the Chief Market Strategist at Purpose Investments
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Sources: Charts are sourced to Bloomberg L.P.
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