Why the Correction Isn't Over Yet

Another year for the record books... The worst month for stocks in a generation... Bull market or bear market?... Why the correction isn't over yet...

What a difference a year makes...

This time last year, U.S. investors were celebrating a remarkable achievement for stocks. As we noted in the January 2, 2018 Digest...

Last Friday, the benchmark S&P 500 Index closed at 2,673.61. This was good for a gain of a little more than 1% in December. But it also marked an unprecedented feat...

You see, 2017 was the first year in history where U.S. stocks ended every single month in the green. Only three other years – 1958, 1995, and 2006, which each had 11 positive months – have even come close.

All told, the S&P 500 rallied 19.4% for the full year. Including dividends, U.S. stocks returned nearly 22% in 2017, among the best annual gains in history.

Of course, 2018 was also remarkable, but for a different reason...

All three major U.S. indexes closed the year in the red, marking the first year-over-year decline in stocks since 2008. The Dow Jones Industrial Average lost 5.63%, the benchmark S&P 500 Index fell 6.24%, and the tech-heavy Nasdaq Composite declined 3.88%. And December's performance was particularly noteworthy.

The final month of the calendar year has traditionally been among the most bullish. According to data from Bespoke Investment Group, December has not only averaged the highest return of any month over the last 100 years (1.55%), it has also closed in the green more often than any other (74%) over that time. But not 2018...

This past December saw the S&P 500 fall nearly 10% – including a loss of nearly 3% on Christmas Eve alone – for the single worst month for stocks since the Great Depression. And as you may have read in the financial media, these declines briefly pushed both the S&P and the Nasdaq into "bear market territory" – defined as a drop of 20% or more from a peak – for the first time since the financial crisis.

However, it wasn't simply the magnitude of the sell-off that made 2018 so difficult...

It was that so many folks – including professional investors – were apparently unprepared for it. We're already reading reports of some well-known fund managers suffering huge losses last year.

Now, don't get us wrong. We're certainly not making light of others' misfortunes. While we did repeatedly warn Digest readers to be cautious – to hold extra cash and "hedge" with some short sales or long puts options – we understand why many investors were caught flat-footed last fall...

Stocks had gone straight up for nearly three years. And the only meaningful correction over that time – during February's volatility panic – was quickly reversed. Most folks had become conditioned to buy every dip.

In addition, many of the most reliable signals that have predicted bear markets and recessions were inconclusive at best. While some warned of potential trouble, others continued to give the "green light" throughout the decline.

So what do we expect as 2019 begins?

Of course, we have no crystal ball. We can't yet know if this is actually the start of a true bear market, or simply another large correction within this nine-year rally. But there are two things we can say with certainty...

First, U.S. stocks are now in a downtrend. Since October's peak, every major index has created a clear pattern of lower highs and lower lows, broken up with short, violent rebounds indicative of short-covering rallies. This type of price action is more often associated with bear rather than bull markets.

Second, by virtually any measure you look at, investor sentiment has not still not reached the levels of fear and panic that have marked significant, long-term bottoms in the past.

For example, the following chart shows the S&P 500 along with the CBOE Equity Put/Call Ratio. This ratio compares how many put options individual investors are buying versus how many call options they're buying. And like other sentiment indicators, it's contrarian in nature.

When folks are piling into put options (bearish bets) relative to call options (bullish bets), this number jumps higher. This tends to be a bullish sign for the market. It signals the "crowd" is too bearish, and at least a short-term rally is likely.

On the other hand, when folks are piling into call options relative to put options, this number shoots lower. This tends to be a bearish sign. It suggests the crowd has gone "all in," and a pullback is likely.

As you can see, the put/call ratio jumped above 1 during the pre-Christmas sell-off. But it quickly reversed and plunged lower during last week's sharp market rebound, and closed Friday at just 0.44...

This is the single lowest reading in this indicator in nearly five years. In other words, according to this measure, investors were panicking last week... but it was a panic into rather than out of stocks.

This is not what we would typically expect to see at a lasting bottom in stocks.

But again, this isn't the only indicator sending a similar message today...

As we've noted several times over the past several months, the CBOE Volatility Index ("VIX") – the market's so-called fear gauge – has remained relatively subdued. Even after the market's decline to new lows last week, the VIX has yet to make a new high.

Likewise, our own proprietary Complacency Index continues to suggest investors are anything but worried. It closed the month of December at 25. While this is again higher than it was last month, it remains well below the critical 30 level that says investors are dangerously complacent.

Meanwhile, according to money manager Fidelity, individual investors have continued to "buy the dip" at their fastest pace in years. As the Wall Street Journal reported on Tuesday...

The year-end stock selloff saddled major indexes with their worst annual decline since 2008 as concerns over global growth intensified, but retail investors are trying to hold on despite the intense volatility...

Fidelity, which is both an online brokerage and the country's largest 401(k) plan administrator, said its customers were buying more than they were selling in the period from Oct. 1 through Dec. 31.

For every sell order from Fidelity's retail brokerage clients in that period, there were also 1.25 buy orders, up from a buy/sell ratio of 1.21 in the year-ago period. Amazon (AMZN) and Apple (AAPL) were among stocks that were in higher demand in the past week.

And while anecdotal, we'll also note that several of the friends and family members we spoke with over the holidays expressed worry about the stock market. But only a few had actually decided to raise some cash or hedge… and no one we spoke with was outright bearish.

For now, we continue to recommend caution...

We don't make official recommendations in the Digest, but we believe the risk of further downside is significant. If you're a conservative long-term investor, we'd advise against rushing back into the market right now.

Instead we suggest waiting for real signs of investor panic – or the start of a new uptrend – before making significant new investments in stocks. In the meantime, continue to follow your stops – which will naturally raise additional cash if the market does continue lower – and reserve new capital only for your highest conviction ideas.

New 52-week highs (as of 12/31/18): none.

We're still sifting through the loads of reader feedback we received over the holidays. We'll publish some of the best later this week. In the meantime, send your questions and comments to feedback@stansberryresearch.com. As always, we can't provide individual investment advice, but we read every email.

Regards,

Justin Brill Baltimore, Maryland January 2, 2019