Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: In recent years, market volatility has increased noticeably but, thus far in 2012, it seems investors have been pretty quiet. Is the market taking more of a wait-and-see approach right now?
Stovall: Yes, volatility has been on the uptick. If you look at the number of days per year in which the S&P 500 has fallen by 2 percent or more in a single day, we had 21 such days in 2011. However, since 2000, we averaged 15, and averaged only five times per year since 1950. So in 2011, we had four times the average we’ve had since 1950 and an average of five more per year as compared with the average since 2000. So whether you look back 10 years or 60 years, volatility has definitely been higher recently.
Right now, however, volatility has simmered down a bit and it’s because the market itself has been on an upward bias since early October 2011. Rarely does the market go up by 2 percent or more in a single day, and it’s usually less than the number of times in which it goes down. So it’s interesting, but the market has definitely climbed a wall of worry and has taken some nice steps along the way, though certainly not very big exaggerated steps. I think that’s because things have happened here in the U.S. that have caused investors to feel as if the U.S. continues to move further and further away from a possible double-dip recession.
Investors are also feeling more encouraged that China will experience a soft landing. Lastly, the European Central Bank’s effort in early December to quell the concerns of a Lehman-type of event, precipitated by the banks in Europe, has gone a long way to easing investors’ minds and allow this market movement to continue to the upside.
EQ: Less volatility might be great for more conservative investors, but do you think this calmer period could be setting the market up for larger swings in the near future?
Stovall: Yes, I do. People have always wondered if high volatility was an indication of downward movements in stock prices. I have actually found that volatility is more of a lagging indicator rather than a leading indicator. What I mean by that is if volatility is at an extreme level, it’s probably because we’re getting closer to the end of the market decline rather than the beginning.
Some people say that market volatility is akin to seismic activity, and that volcanologists will be forecasting an impending volcanic eruption based on an increased number of earthquakes that are being monitored. I think the reverse is true when it comes to market timing in that you’re better off being somebody who sees an excessively low tide and realizes that a tsunami is on its way.
Going back to the early 2000s, whenever we have had only two times in the trailing 20 days where the intraday volatility exceeded 1 percent during the down days, that was a low-water mark that typically indicated that sooner or later we would likely experience a decline of 5 percent or more. This has been fairly accurate, but of course, the market could stay in a relatively low volatility mode for quite a number of months. But in each observation, once it touched that, we ended up having a decline of 5 percent or more before we started to see volatility increase and thereby reset the clock.
EQ: You noted in this week’s Sector Watch that defensive sectors have historically performed a bit more favorably than cyclicals in February. In this case, Technology may be the most susceptible to a pullback. Why is that?
Stovall: Everyone seems to remember that September is the worst month of the year for the S&P 500, but a lot of people forget that February is a close second. Actually, since 1970, September and February are the only two months in which the S&P 500 has recorded an average decline. It probably comes as no surprise then that whenever we do have a strong three-month period (November, December, and January), the market tends to take a breather and digest these gains before moving on to relatively favorable results in March, April and May. This time around I don’t think it is likely to be any different. The market has risen more than 20 percent since the early October low and recently Technology has been one of the strongest performing groups even though the cyclical sectors do tend to outperform the defensive sectors coming off severe corrections or minor bear markets.
Mark Arbeter, S&P Capital IQ’s Chief Technical Strategist, believes that the price action for Technology has gone parabolic and, as a result, has become more vulnerable to a fairly sharp correction or at least a very sharp pullback, more so than what he would anticipate for the market as a whole.
So S&P’s Equity Strategy Group decided to downgrade its recommended exposure to Technology to marketweight from overweight. We still like the cyclical bias that the market will likely experience, at least over the next several months, but we think there could be a better re-entry point for Technology down the road.
EQ: Are there any indicators or signs that investors should look for to confirm whether a pullback or correction is occurring or about to occur?
Stovall: First, the exceedingly low level of volatility is a good indication but not a guarantee that a decline is around the corner. So then the next question is whether other factors such as fundamentals and valuations are stretched at this point. We don’t necessarily think that they are. P/E ratios are more than 20 percent below the median since 1988 or when Wall Street started looking at operating results. On a relative P/E basis, the market still looks attractive, but if you look at the relative strength indicators or other technical indicators, our chief technician believes that the market is overbought and is susceptible to a decline of anywhere from 3 percent to 5 percent. It’s very hard to know exactly where the decline ends.
Will it end as a pullback (5 percent to 10 percent), a correction (10 percent to 20 percent), or slip to bear-market mode, which is in excess of 20 percent. You basically have to wait and see where everything falls out. The overall magnitude and duration are things that are likely to be charted, but from a fundamental perspective, it’s very difficult to know where the bottom is.
