No More Black Mondays

In a true demonstration of impeccable and apropos timing given the recent volatility we have experienced, yesterday marked the 27th anniversary of one of the stock market’s most infamous and chronicled events. “Black” Monday, October 19, 1987 was one of those multiple standard deviation occurrences that statisticians will tell you are not supposed to ever really happen, but as is the case more frequently than most realize, it of course did happen, and its impact is still being felt today even as there are fewer and fewer investors around that actually had to suffer through it. The Dow Jones Industrial Average lost over 22% of its value that fateful day, a decline that takes on even greater significance when you consider the Dow hasn’t undergone a 20% or greater slide over any time period since the 2008-2009 bear market (we came close in 2011, but no cigar). Having that much wealth wiped out in a single session will understandably leave its mark in financial lore, and since then, it has been responsible for countless market gurus attempting to predict when the next such impossible Black Swan crash will occur. You may have even heard some rumblings lately that the current market pattern is similar to 1987, a belief that makes for a good headline but is most likely better at generating mouse clicks than it is at actually forecasting the direction and magnitude of the next move. Anything can happen, of course, but I would like to point out that in 1987 the DJIA had soared an incredible 44% year-to-date at its August high, while our current 2014 version did not even manage a 5% gain at its September 19 top. There are still some issues under the hood of this market, but unless we see some drastic deterioration, I remain hopefully optimistic that the “once-in-a-lifetime” 1987 crash will continue its path toward being just a distant memory and that history will not subject us to a 2014 variety.

With that being said, the equity markets still do not feel completely healthy, and it remains to be seen if last week’s wild rollercoaster action was enough to fully shake out the weak holders so the uptrend can resume. As we wrote in both Thursday’s and Friday’s Morning Tack, it certainly feels like we got a selling climax on Wednesday, but this week will be very crucial in determining whether or not we have truly begun the bottoming process. Strangely, I would have felt a little bit better if we had lost just a tad bit more last week in order to fully get the 10% correction in the S&P 500 that we have been expecting since the beginning of 2014. It’s now been almost 2 ½ years since the last 10% dip, and I’d like to go ahead and get it out of the way, if only so we can stop talking about it. By my math, the S&P 500 will need to touch 1817 in order to make it official, and so we almost seem destined for at least an undercut low to take it out once and for all. As I wrote Friday:

The action most consistent with a bottom would be that we get a decent oversold rally that takes us up near the major moving averages before another round of selling brings us back down to challenge Wednesday's low. Then, if the low can hold, we will have an opportunity to take a real shot at the next leg of the secular bull market that we still believe is in effect.

Even if we do get an undercut low that falls slightly below the one from last Wednesday, it does not negate the bottoming process, in my opinion, but ideally it would not stay under that low for long or stretch too far underneath. We do not want to see evidence of renewed broad-based selling, so hopefully any further weakness takes place on lower volume and is not as sharp as what we saw the past couple of weeks. The fact that we are having a pullback is not altogether surprising given the run we’ve had [the fifth longest streak of days above the 200-day moving average in the S&P 500’s history, according to Bespoke Investment Group (see Chart 1)], but we’re obviously near levels where we want to start to see some increasing demand from buyers who feel we’ve corrected enough.

Along those lines, it would be a boon to the market if the small caps can continue their recent spurt of outperformance. Perhaps lost in all the craziness of last week was that the Russell 2000 actually managed a gain of around 2.75%, particularly impressive considering the small caps have routinely underperformed large caps since the beginning of March. In Chart 2, you can see how the relative strength trend has been steadily in favor of the S&P 500 over the last few months (small caps are outperforming when the line is moving up and underperforming when it is moving down). One sign of a healthy market is when we have broad participation across the different classes of stocks, and most strong bull markets have historically featured the small caps as leaders, not laggards. So it would likely only help things to get some renewed interest in the smaller, more speculative stocks. At this point, we cannot tell if this recent pick-up in strength in the Russell 2000 is the beginning of a new trend or solely a result of small caps being relatively more oversold than the large caps, but I will be watching the line in the aforementioned chart very closely and would like to see it start rising again like it mostly has done since the 2009 bottom.

We are now in the heart of earnings season, too, which will continue to provide sort of a status report as to how much the perceived global growth slowdown is affecting actual company performance and future outlooks. Analysts on the Street have been ratcheting down earnings estimates recently, having lowered forecasts for 728 companies in the S&P 1500 over the last four weeks compared to raising estimates for only 372 (source: Bespoke Investment Group). The question now becomes whether or not analysts have lowered the market’s expectations enough to allow for some positive surprises, as a number of earnings and revenues beats could be an impetus to get things rolling again.

Europe may be playing its respective part, as well. Despite being the setting for many of the current issues the world markets face, the Continent actually finished last week with somewhat of a flourish and the iShares S&P Europe 350 Index Fund (IEV/42.22) looks to have made a hammer candlestick pattern, which is typically bullish in the short term (see Chart 3). If things can settle down across the pond and U.S. earnings turn out not to be the disaster many fear, it could set us up for another run at the highs to finish the year.

The call for this week: We are still in the early stages of what could be a bottoming pattern, but internal market indicators such as breadth readings still need to show improvement. Friday’s high in the S&P 500 was stopped practically right at the 200-day moving average and that appears to be the first resistance level in the way of higher prices. If we cannot overcome the 200-day soon, then we could fall right back toward the lows of last week, perhaps touching the 1817 point that would give us the true 10% correction. The April low sits right underneath at around 1815, which should provide fairly strong support.

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