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Correction Time

S&P 20 Yr

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Last week, the stock market had the worst week of the year, and the worst week since 2007.

Today, we open with another selloff that has blown through support at the 150 and 200 day moving averages which have acted to turn back selloffs over the past few years.

We are off about 4% as I type this, taking the S&P 500 index down 8% year-to-date.

Earlier in the year, I wrote on the blog that we were raising cash in client accounts – roughly 5% of the equity value – because the indicators I follow and the valuation metrics I use were telling me that the market had gotten to an extended level and we were due for a pullback.

S&P YTD

This graph shows you what has happened since then:  the stock market has been in an eight month sideways trading pattern, moving above the 2100 level 13 times then pulling back.  The buy-the-dippers stepped in each time and turned the decline around, pushing it back above the 2100 level.

Until this time.

So what’s different this time?  Global Deflation

Global Deflation is a secular trend driven by:

(1) Demographics- Japan, Europe, and China are all reproducing at less than replacement levels with the US roughly flat due to immigration, putting a cap on economic growth as more and more money goes to transfer payments to and medical care for an aging population instead of into economic growth;

(2) China’s economic slowdown as it transforms into a consumer economy from a producer economy, yielding a marked decrease in the need for commodities like iron, copper and petroleum;

(3) a slow growth US economy at 1.8% GDP which is less than the 2% target set by the Fed;

(4) the September target date for the Federal Reserve to raise interest rates was gaining acceptance given the strong unemployment number (at least strong to our government that doesn’t count those who have left the work force as adding to the decrease in the rate);

(5) continued economic weakness in Europe leading to reduction in the need for commodities;

(6) global debt levels have increased to an estimated $225 Trillion or roughly 300% of global GDP that puts a lid on future growth; and

(7) the likelihood that much of that debt never gets repaid – e.g., Greece, Cyprus, et. al.

In terms of valuation, the most recent quarterly results for corporate earnings were underwhelming – the strong dollar has hurt our export driven manufacturers and global corporations from two perspectives:  (1) our products are more expensive in foreign markets given the higher dollar, which lowers sales; and (2) those sales in foreign currencies are lower when translated back to dollars.

The S&P was trading at a P/E ratio of 18.25X forward earnings and has since adjusted to 16.5X forward earnings as of Friday – that obviously will be lower today, more like 16.25X forward earnings.  This gets us closer to the long-term average of 15X, but still doesn’t approach Germany, a country that is in a similar place in its business/economic cycle, that has a 14X P/E ratio.

When we are in a sell off like this, there are two things we want to know:  where will it stop and when should we buy.  To help answer that question, we need to figure out where support levels are that would cause buyers – in particular the computers who have been programmed to buy at support levels – to step in a buy the dip.

S&P 15 months

The graph above shows you a couple of those levels that go back to the October 2014 sell-off.  The graph below gives you a close-up view and I’ve circled the 1863 level on the S&P 500, which is the likeliest support level since that is where the market closed on the day that was the reversal day.

S&P 500 Oct 2014And my final graph for you is one that shows you the S&P 500’s movement today:

S&P TodayYou can see the market was in free fall at the open and went down to 1868 (right at support) – and buyers stepped in driving us up 5%.  As I type this, the market is headed back down from that level – BUT will probably bounce around all day within this range of down 8% to down 3%.  If we can close today near the top of the range, this will be a good sign.  If we close at the bottom of this range or even lower, that is a sign that tomorrow will likely be another sell off day at the open.

So what gives me some confidence that this is just a revaluation and not the start of some secular decline that will take us down like the 2008?  We do not have a financial system in crisis like we did then, like we did in 2001, like we did in 1998, like we did in 1987.  We simply have a market that got overvalued based upon investors paying more for earnings than they were worth due to the expectation that the Fed would keep rates low forever, that China would continue to be the growth engine that powered the world, and that corporate earnings could continue to grow.

So what’s my plan?  To put some cash to work and buy a few of our favorite companies that have sold off, and focus on companies that have primarily domestic exposure.  There is no way to catch the absolute bottom of any particular stock’s sell off – prudence dictates that you put money to work during the sell-off a little bit at a time.

We started to use some of our cash on Friday afternoon, buying Southwest Airlines and Cal-Maine Foods.  Southwest is an all domestic airline that should benefit from oil below $40 and Cal-Maine should benefit from consumers focusing their purchases on food staples if we have some sort of economic downturn to go along with the stock market downturn.  We will continue to put cash to work in a determined manner in companies that are significantly lower than their 52 week average – remember stock prices are all about earnings growth so we will focus on companies with growth levels higher than the market average or ones that we anticipate will be above market averages when this all shakes out.

 Mark