Bungie Monday


US stocked dropped 5.3% on the open with the Dow Industrials shedding 1089 points in 5 minutes.  By mid day, the decline was a mere 0.9%.  Many investors took that rally as the last opportunity to get out of stocks, so selling pressure returned in the afternoon, leaving the major averages down 3.9% on the day, 9% over the last three sessions, down 6.8% on the year and down 11.3% from the record high set May 12th.

Officially a correction, but could this selloff become a bear market?

A correction is defined as a decline of 10% from a previous high; a bear market is a decline of 20% or more. We say, "no bear market."  Bear markets result from:

  1. Highly over valued stocks, as we saw in 2000
  2. Severe bank stress caused by over leverage, as we saw in 2008-9.

Neither of these factors is significant right now.

By the Morningstar Fair Value model: Stocks were on the high side of average over the last two years, so relatively hard to make money.  In 2011, stocks were grossly undervalued, so easy to make money in 2012.  As of now, stocks are back in undervalued territory, about 8% undervalued.  In 2000, stocks were overvalued by a record 110%.  That's what allowed the NASDAQ to fall 75% over two years.

Ever since 2009, banks have had little opportunity to take on investment risk.  The firms that are at risk right now are hedge and mutual funds who blithely bought up emerging market debt in recent years chasing yield.  Those markets are illiquid right now.  Depending on redemptions those funds may well have to dump positions as deep discount, which only acerbates the problem.

Meanwhile, average investors are terrified.  CNN Money produces a helpful "Fear & Greed" Index. As of this afternoon, the index was at the limits of extreme fear. As we have seen in year's past, this index is a pretty good contrary indicator.  The last time the index looked this bad was October 2014 - two month later the S& P 500 was 11% higher.