Dead Cat Bounce Likely in the S&P

This pullback should help you weed out the fair-weather stocks in your portfolio

   

Stocks took their biggest tumble of the year on Wednesday without any catalyst, which is the worst kind of catalyst of all. It’s like a meteor striking the earth. No special reason, but a fireball just shows up and crashes in your backyard.

Possible Causes of the Pullback

Markets have been heavily overbought, expectations for earnings growth for the next quarter are much too high, the housing market is not nearly as strong as we have been given reason to believe it is, and then we learn from Fed meeting minutes on Wednesday that the extension of low interest rates far into the future might be amended to “kinda far” or “somewhat far” or “maybe just a little bit far.”

In my view that new ambiguity about exactly how long the Fed will keep interest rates super-low was the real drive of the decline this week, as one of the true foundations of the 2013 rally was that the Fed was going to keep its monetary policy pedal to the metal. Anything that shakes that point of view is going to upset investors who have been addicted to cheap money — and with big profits in hand they will sell first and ask questions later.

Find the All-Weather Stocks

Now the good thing about pullbacks is that they are a great time to learn exactly which strong stocks are for real, and which are pretenders. While there are wanna-be stocks that go up in a broad advance, only a few will manage a major downturn with dignity and grace — and those are the ones you want to focus on for the next recovery period.

The decline is not big enough or long enough yet to make that determination, but preliminary analysis is pointing to big-cap food makers like General Mills (NYSE:GM), tobacco makers like Altria (NYSE:MO) and Lorillard (NYSE:LO) and drug makers like Novartis (NYSE:NVS).

Now if we look at what actually tumbled the most some very interesting patterns emerged. Analysts at Bespoke   Investment Group   broke the S&P 500 into deciles (10 groups of 50 stocks each) based on stock performance in 2013 heading into Wednesday.

They then calculated the average change for stocks in each decile today. And it turned out that the 50 stocks that were up the most in 2013 heading into today averaged the biggest declines today at -2.70%. The next 50 best performing stocks YTD were down the second most today with an average decline of 2.09%. That is pretty typical behavior for a pullback in an uptrend.

Will This Trigger a LOB Situation?

So what’s next? From a technical point of view, bulls and bears are going to fight like cats and dogs, to mix metaphors, over the 1,500 to 1510 level of the S&P 500. If the bulls lose, we could be looking at a very material decline that has the potential to wipe out most of the year’s gains. It would trigger a condition known in the industry as LOB, which means “look out below!”

It’s too soon to say if that will happen, however, because bulls and companies with big stock buyback programs have been fantastic at dusting themselves off after every setback and plowing new money into equities. As long as the S&P 500 stays over its 50-day average, which is currently 1,471, then the uptrend remains in place and this sell-off will be seen as just another buying opportunity.

S&P Testing the January Breakout by March 6?

My friends in the hedge fund community who follow the Gann cycles, however, are a little more pessimistic. I won’t go into all of their witchcraft and voodoo, but they essentially argue that the market benchmark has the potential to slip all the way back to the 1,455 area. That would constitute a very normal “test” of the January breakout.

If that does occur, it would likely be seen as a successful test and stocks would likely turn right around and gallop to brand-new highs. Stocks always fall a lot faster than they rise. So if a decline does get underway, a date on the calendar to stare at for a bounce would be March 6, the four-year anniversary of the bull market.

Personally I think that if there is a bounce today  it could be of the “dead cat” variety, and an opportunity to tidy up the sale of profitable positions. My expectation is that a decline at least to the 50-day average, which could be as low as 1,460 by the time the low arrives, would ensue. In conjunction with that, my research suggests the potential for a dull, sideways market for two to four months, followed by a renewal of the uptrend into year-end.

InvestorPlace advisor Jon Markman operates the investment firm Markman Capital Insight. He also writes a daily swing trading newsletter, Trader’s Advantage which aims to capture profits of 15% to 40% and often as much at 100% to 200% in less than 90 days. 

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