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Bear Territory? Never Fear.

Written By Briton Ryle

Posted September 18, 2014

More than 50% of tech stocks are in bear territory! Small caps are more than 10% below large caps over the past 6 months! The long-awaited correction three years in the making is finally here! Sell! Sell! Sell!bear

[Screech to a halt.]

Hold on a second, Chicken Little. Let’s not lose our heads over the latest configuration of stock market indices.

Yes, the majority of technology-laden NASDAQ stocks are 20% below their 52-week highs, which is technically bearish territory. Yes, the Russell 2000 index of small cap stocks is sitting at -4% over the past 6 months, while the Russell 1000 index of large caps is at +6.5% over the same period. And yes, small caps historically do lead the rest of the market down.

But now that the Federal Reserve has just yesterday reminded us for the umpteenth time that it is in no hurry to raise interest rates at all, we seem to be at an intersection with two traffic lights – one showing red (the indices), and the other showing green (the Fed).

Which should we obey? You know the mantra… “Don’t fight the Fed.”

So what are we to make of the conflicting sell signals we’re receiving from the indices? To understand what the indices are doing we need to remember just one thing… indices are backward looking, not forward. They aren’t showing us what is about to happen, but only what has already happened. The Fed is the one telling us what will happen.

The point is made clearer when comparing the indices to one another.

Price Discovery At Work

Before examining the indices’ current configuration, we need to get a handle on a market’s natural tendency to overshoot and undershoot its way to its true level.

Five years of ultra-low interest rates have boosted companies that are highly capital intensive, such as technology and biotechnology companies that spend a fortune on research and development. This is the perfect environment in which these stocks flourish, which is clearly evident in the graph below.

Indices NASDAQ Russell since 2009 correction


Notice which indices have performed the best and which have performed the worst since the economic recovery began in March of 2009? The tech-laden NASDAQ (yellow) and the small cap Russell 2000 (burgundy) have lead the way up, followed by the large cap Russell 1000 (blue) and the broader market Russell 3000 (orange) in the middle, while the mega cap Russell 200 (beige) and the largest cap Russell 50 (black) bring up the rear.

Now isn’t it quite likely that on this multi-year climb upward many stocks would have overshot their true price levels?

Absolutely. The longer we go without a correction, the further off base these high-fliers will deviate. A correction, therefore, is actually a beneficial occurrence, as it finally brings any and all stocks that have deviated from their true levels back to where they should be.

This is precisely what happened in the middle of the graph, toward the end of 2011. Notice how the NASDAQ and Russell 2000 were leading all the others back then as well? Notice how they quickly fell back in line with the large cap Russell 1000 and broader market Russell 3000? This is price discovery at work. Whenever a price deviates from where it should be, it always reverts.

Yet the important thing to remember here is that such a correction back to true levels is not the end of the run. After the 2011 correction the high fliers took off once again. Why? Because the Fed was still highly accommodative, keeping interest rates low.

It was only a matter of time before techs and small caps would once again overshoot their true levels, and once again correct back down to their proper places, as has been happening now.

What a Discovery Looks Like

If we zoom in to the thick of that 2011 correction from July 22 to August 8, we find a classic corrective configuration, as noted in the graph below.

2011 corrective configuration indices


A corrective configuration is essentially a bullish configuration flipped upside down, with the largest capitalized Russell 50 and 200 at the top, the large cap Russell 1000 and broader market Russell 3000 in the middle, and the tech-heavy NASDAQ and small cap Russell 2000 at the bottom. Those what went up the most are those that come down the most, while the largest capitalized companies hold up the best due to their more reliable cash flows and generally lighter debt loads.

Now let’s compare the current configuration over the past six months in the graph below.

April 2014 to September 2014 indices


Isn’t that just a peach? The configuration of the indices over the past six months is in precisely the same order as that of the 2011 correction – with techs and small caps at the bottom, and the large caps at the top.

But what is this really telling us? Is this telling us that we are about to experience another dive like that of 2011, with plunges ranging from -15% to -22% as noted in the second graph above?

It might be, as no one knows ahead of time where a correction will end. For this reason, investors should be keeping some spare cash in their portfolios to ensure they don’t get any margin calls, or run the risk of having their positions force-liquidated at a loss.

Yet there is one other reason to have extra cash in your account… to buy. Just as the 2011 correction didn’t end the bull run on account of a highly accommodative Fed, so too the current corrective configuration won’t end the run now on account of a still highly accommodative Fed.

Do You Recognize a Gift Horse?

Just as the 2011 correction was a buying opportunity in disguise, so too the current correction (whether it’s over or just beginning) is a gift horse looking for riders.

How can we be sure the bull run isn’t over? Because the Fed is still not finished with its two mandates: maximum employment and price stability.

As it stands currently, unemployment at 6.1% is still too high. It’s even worse when factoring in the unemployed who are considered only marginally attached to the workforce. The two groups combine for a real unemployment rate of some 9%.

As for price stability, 2% annual inflation is considered stable, with anything below that considered below optimum price growth. Although some prices are increasing by more than 2% per year, wages are still stagnant. The Fed won’t be satisfied until 2% annual inflation seeps into wages as well.

And let’s not forget the Fed’s third and unofficial mandate – the housing recovery, which has been meandering sideways for nearly all of 2014.

Thus, any pullbacks from recent 52-week highs, and any drop in techs and small caps should be seen for what they are, just normal price discovery as the market knocks the deviant high fliers back in line to where they should be. It’s just a simple adjustment, not a rout in the making.

Investors should be prepared to purchase on the dips, rebalancing their stock-to-cash ratio as prices change. Holding 80% stocks and 20% cash near a market top would turn into something like 70% stocks and 30% cash after a correction. When you see that your stock portion has dropped below your desired ratio, that’s the time to rebalance back to your 80-20 split.

In so doing, you’ll be picking up extra shares at cheaper prices, remaining in the game to benefit from higher prices down the road.

So get your saddles ready. A gift horse may be heading your way.

Joseph Cafariello