This month is sure to go down in the books as a perfect illustration for why October brings out the ghouls and long knives on Wall Street. It’s the start of companies’ final sprint to the end of the year, and that makes it time to confess that the idealistic goals set out at the beginning of the year are not working out.
To be sure, there are much broader specific reasons for the market to have flipped out this month — the emergence of Ebola as a global contagion concern, the troubled military plan to battle the Sunni extremists in Syria, and a bitter midterm election battle for Congress, to name a few. But, at the end of the day, corporate earnings prospects are what drive stocks, and that is the source of most of the pain seen on Wall Street this month so far.
The broad market was down 2.3% last week, and the S&P 500 Volatility Index (VIX) zoomed 32.6% higher in response, which reflects how quick institutional investors have been to hit the panic button. It means that they have bought about 15x more protection than they really need…which is about par for the course, as we have seen in months past.
Now, if you are like a lot of traders, maybe you think protection is a good idea. Yet the reality is that the recent pullback of around 4.5% from the September high is not likely to signal the start of a new bear market. This is because most bear markets occur on the cusp of, or during, recessions. They don’t occur during well-established recoveries, which is the current state of affairs here in the United States.
My expectation throughout this year has been that the S&P 500 would have a shot at closing around the 2,000 level, and I still believe that will be the case. Looking a little further out, I am looking for around 3,300 before the current bull market is over.
Why have confidence? Well, there have only been 12 full-blown bear markets since 1929, which are peak-to-valley declines of 20% or more. There have also been 14 recessions since 1929. Most of those bear markets occurred at or very close to major economic downturns, which only makes sense, since corporate earnings collapse during recessions and investors’ desire for them naturally wanes.
While certain industries are certainly in a funk, valuations are not badly stretched, and the globalization of labor has helped keep wage demand in check, reducing inflation. And lower inflation always leads directly to higher price/earnings multiples and thus to higher stock prices.
My personal view is that, so far, the current setback in prices is tracing the path of a typical 5% to 10% correction. We haven’t had one for a while, and that makes this one feel worse than it is. But if you were around in 1999, the best year for the Nasdaq 100 in history, when it gained 100%, you will recall that there were four separate 10% corrections in that single year.
The bottom line is that corrections serve to make you more aware of valuations and the danger of taking on more risk than you can stand. Take that lesson, but don’t burn the primer.
The CounterPoint Options system recommends playing for a decline in the VIX and a market rebound via puts on the iPath S&P 500 VIX Short-Term Futures ETN (VXX).
Buy a 1/3-sized position in the VXX Nov. 22nd $34 puts (VXX141122P00034000) at current levels — around $3.50 — for target $6.00.
Jon Markman operates the investment firm Markman Capital Insights. He also offers a daily trading advisory service, Trader’s Advantage, and CounterPoint Options, a service that helps individual traders make steady, consistent profits with volatility-related instruments.
