Day of the Dead?

I wasn’t planning to write 3 daily emails in a row, but after today’s stock market reversal, I thought it would be a good idea going into the weekend.

As you probably know, stocks took back yesterday’s gains and a bit more today. So in 3 days, we’ve had 3 big moves: down—up—down. So should Monday be up? Who knows; investors have all weekend to stew about it.

Yesterday, it seemed pretty clear that the rally was driven by the better-than-expected GDP report. So what drove today’s drop? Whatever it was, I don’t think it was news. The only significant report to come out today was consumer spending, which was down –0.5% for September after several months in a row of increases. But this was exactly the number that economists expected, and was largely the result of a decline in car purchases after the expiration of the “cash for clunkers” program (see yesterday’s email for a discussion of this). Outside of motor vehicles, most areas of consumer spending actually increased.

Today was the last trading day of the month, and the last day of the fiscal year for many mutual funds. So “portfolio window dressing” could have had an impact on today’s trading. Also, volatility has been increasing rapidly over the past few days, which often scares people out of stocks. Volatility tends to peak at inflection points in the market, particularly at bottoms. Currently, we’re at about the same level of volatility as we were at the market’s July low, which was the end of a –7% correction; as of today, the S&P 500 is down about –6% from it’s October peak.

It thus seems that we’re in the process of forming a base from which another significant rally can start. Whether it begins as soon as next week or later is impossible to guess, but I doubt it will take more than a few weeks for the market—and investor sentiment—to turn around again. Interestingly, investor sentiment is also at about the same level as it was at the July bottom, yet the S&P 500 is nearly +18% higher than it was then. The wall of worry that typically drives bull markets remains solid.

Yes, this has been a disappointing week, and scary, too, owing to big daily price swings. But the S&P 500 is down barely –2% for the month, which is only 1/10th of its drop of last October. And this came after 7 consecutive months of gains. A pause in the upward momentum shouldn’t be a surprise. I think this pause will be one that refreshes, similar to the one in July. You may not remember, but back then the stock market made no headway at all for 2 full months, and was actually –5.4% lower in early July than it had been in early May. But those who stayed put and didn’t panic have already been rewarded with a double-digit gain.