Understanding a Confusing Stock Market…Inside and Out

By: Money_Morning

Michael E. Lewitt writes: The long overdue stock market correction continued this week as a European growth scare was compounded by fears about the potential spread of Ebola to send the markets lower.

A strong rally on Friday allowed the major stock market indices to stabilize for the moment and show relatively minor damage on the week, but many hedge funds suffered larger losses after being forced (or forcing themselves) into realizing losses as the markets reached a selling climax on Wednesday, October 15.

That day, the Dow Jones Industrial Average traded down 470 points at its low before recovering to close down only 173.45 points.

Even more dramatic was the action in Treasuries where the yield plunged by 30 basis points at one point to 1.83%, its most dramatic intraday move since the collapse of Lehman Brothers…

By the Numbers

Thanks largely to the reassuring whispers of central bankers, markets recovered steadily throughout the rest of week but there is likely more turbulence ahead. It should not be taken as a sign of sustainable market strength that it required Fed official talking about QE4 to steady the market. The Fed is just days away from ending QE3 and the S&P 500 is only down 5% from its closing high of 2,011.36. The last two times the Fed exited QE, the S&P 500 sold off by about 20% in subsequent months. In view of slowing global growth, geopolitical instability and the added wild card of Ebola, it would be very surprising if we got off more easily this time than the last two times the Fed stopped monetizing debt.

On the week, the Dow Jones Industrial Average lost 164 points or 1% to close at 16,380.41. The S&P 500 dropped 19 points or 1% to end at 1,886.76, far above 10% correction territory of 1,810. The S&P 500 came close to it on Wednesday, hitting 1,820.66 intraday (down 9.5% from its high) before recovering.  Small cap stocks, which had been pointing to a sell-off in recent weeks, did much better and could offer a glimmer of hope that the technical picture is improving. The Nasdaq Composite Index only dropped by 0.4% to close at 4,258.44 while the small cap Russell 2000 rose by a strong 2.8% to end the week at 1,082.33. In view of the extreme volatility seen during the week – at one point the VIX traded over 30 intraday and closed at 25.27 on Wednesday, more than doubling from its September 17 closing level – the drops in Dow and S&P 500 were almost immaterial, which is another reason to think there may be more to come.

The 10-year Treasury yield ended the week at 2.22%, down roughly 10 basis points but far above its Wednesday intraday low. High-yield bonds also saw significant moves as the average spread widened to about 5.1% from 3.4% this summer.

Market Liquidity Slows

Moves in high-yield bonds as well as the dramatic movements in Treasuries on Wednesday point to the troubling illiquidity in bond markets today. Many observers are touting high-yield bonds as attractive now that their average yield is approaching 7%, but this demonstrates a loss of perspective and lack of historical memory. The only reason this yield looks compelling is that investors have been yield-starved for so low that 7% looks like an oasis in the midst of a desert.

One of the traps that high-yield investors fall into it is focusing on bond spreads, which are a fixed income tool applied to a hybrid debt/equity instrument. Spreads may be widening but Treasury yields are dropping, keeping overall yields low. This leaves investors living off still stingy absolute returns. High yield bonds offering yields below 7% are not attractive and anyone telling you otherwise is not someone you should want managing your money because they are drawing you into a trap.

As has been the case for the last three years, the only parts of the corporate bond market that are attractive on a risk-adjusted basis are a select universe of event-driven bonds. The good news is that these bonds have dropped in price along with the rest of the market and are now much more attractively priced than they were a month or two ago. Otherwise, corporate bonds won't get interesting until the average spread is wider than 700 basis points (which would equate to a yield of close to 9%).

Minor losses in the Dow and S&P 500 are disguising much larger losses experienced by many so-called "smart money" investors who were flushed at the height of the selling panic. Investors in funds who realized such losses should be asking how and why their managers found themselves in a position where they were forced to sell at the least opportune time, particularly since the market was clearly overextended and due for a pull-back.

Why weren't these investors, who are paid huge management and performance fees for their expertise, prepared for such a reversal? Further, while markets likely have further to fall, most signs continue to point to this being a normal correction and not the beginning of a prolonged bear market that would justify selling out now. As noted above, while the S&P 500 sold off by about 20% the last two times the Fed exited QE, the market did not enter a prolonged bear market. Instead, it bounced back and rallied to new highs. Investors that sold at the bottom of these corrections realized unnecessary losses due to poor risk management and portfolio positioning.

Today, with the yield curve still steep, unemployment dropping and GDP growth running at 3%, there is minimal chance that we are entering a recession, which is normally a precondition for a bear market.  Instead, the markets appear to be experiencing a long overdue correction within the larger context of a continuing bull market. There may be legitimate reasons to question whether the bull market should continue because valuations are stretched and there are genuine headwinds in the form of slowing growth outside the U.S., geopolitical instability and now the wild card of Ebola.

But until the yield curve flattens more than it has, there is little historical precedent to expect the bull market to end. Well-positioned investors who entered this period unleveraged and with dry powder are the types of people you want managing your money, not leveraged speculators who were forced to sell and realize unnecessary losses.

The case for further selling is compelling. In addition to a genuine growth scare in Europe, the Ebola news, increasing evidence that the United States is going to have to put boots on the ground to effectively battle ISIS, and the likely failure (and best case certain delay of the upcoming November deadline) of the Iran nuclear talks, there is more than enough bad news to worry markets for the rest of the year.

No doubt the sharp drop in oil prices will be a boon for consumers heading into the holiday season, but from a stock market perspective lower oil is going to take a huge bite out of the earnings of one of the largest sectors in the S&P 500. From a geopolitical perspective, lower prices are destabilizing as they move Venezuela closer to default and increase pressure on Vladimir Putin to so something reckless like cut off gas supplies not merely to the Ukraine but to Europe this winter. If the price of oil drops further, it is likely to lead to unintended consequences that are more negative than positive for markets and geopolitics.

Dollar strength is also a double-edged sword. While it is one of the contributing factors to the drop in oil prices, it will hurt multinational earnings.  Lower oil and a stronger dollar are not unalloyed positives for markets. For example, the stronger dollar will mute the effect of lower oil prices for oil producers. In today's multidimensional world, these price movements rarely have simple consequences.

When other factors are destabilizing the market, moves in key commodities such as oil or the dollar (the world's dominant commodity) can send markets reeling as they did this week when plunging oil prices sent stock investors into a panic. Markets deal much better with the status quo than with rapid changes and right now we are in a period where the changes are unfolding more rapidly than markets can absorb them.  And when markets can't digest change, they sell first and ask questions later. That is what we've been witnessing over the last couple of weeks and are like to see further evidence of in the weeks ahead.

The Better Pick of Two Internet Giants

Third quarter corporate earnings have been mixed so far with some notable misses. Netflix, Inc. (Nasda: NFLX) reported a huge miss as its earnings and subscriber growth fell far short of analysts' estimates.

The stock plunged $86.89/share on the news to a still lofty $361.70 on Thursday (the day after the release) and then lost another $4.61/share on Friday despite reports that Mark Cuban had bought shares because he thought they were cheap.

One has to wonder how any stock trading at 100x earnings can be considered cheap, but Mr. Cuban must have his reasons.  Internet bellwether Google Inc (Nasdaq: GOOG) also missed earnings estimates on higher spending and saw its stock drop by $13.34/share to $511.17.

Unlike NFLX, there was nothing in GOOG's report to raise concerns about the company's long-term dominance. NFLX, on the other hand, is facing new entrants in its business including HBO, which announced the launch of a new streaming service for non-cable television subscribers this week, as well as sky rocketing content costs. Amazon.com, Inc. (Nasdaq: AMZN), another grossly overvalued stock but a wonderful company, offers serious competition for NFLX's streaming service and also offers customers the ability to purchase a Hazmat suit if they are really worried about Ebola.

NFLX stock remains grossly overvalued and should be avoided. Earnings season may turn out to be sideshow this quarter, however, if the other things worrying the market don't subside pretty quickly.

Source : http://moneymorning.com/2014/10/19/understanding-a-confusing-market-inside-and-out/

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