Stock Market Pullbacks and Bounce Backs

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Nov 15, 2017 11:11:13 AM

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stock marketYesterday, I did an interview with TheStreet where I stated that I thought the market had some more room to rise before the end of the year. Given some weak days and rising fears that the rally could be breaking down, I thought it would be worthwhile to outline exactly why I think that—and what I will be watching for to see if I need to change my mind.

Some context

First of all, let’s add some context. The market (that is, the S&P 500) hit its all-time high a week ago. Since then, we have seen a bit of a pullback, albeit a small one (less than 1 percent). Just for the record, in the past three months, we have seen five of these pullbacks from new all-time highs, only to have the market move upward. It is too early to panic just yet.

Political uncertainty

Second, in the days that we saw that pullback, we also saw serious problems emerge with the Republican tax plan, elections that suggested the midterms could put a divided government back in place, and the Saudi government arrest many of its senior people. There was a lot of political uncertainty over a couple of days. From a stock market perspective, yesterday we saw General Electric, one of the blue chips, get absolutely hammered as it cut its dividend. Given everything bad that has happened, the real question is not why the market pulled back. It’s why it has stayed as high as it has.

Sound fundamentals

Third, the reason the market has been resilient remains the same: the fundamentals are sound. Earnings growth for the S&P 500 came in at almost double expectations. The economy continues to grow. Confidence, both consumer and business, remains quite high. Simply put, conditions remain good. As such, a sustained pullback—while possible—is not probable and is certainly not something to worry about just yet.

Let’s take a moment to remember what normal looks like. In a normal market, pullbacks of 5 percent—even 10 percent—are fairly common. In a normal market, what we have seen so far doesn’t even qualify as volatility. We could see the market drop quite a bit more before it really starts to look worrying.

When will I start worrying?

For the S&P 500, the 200-day moving average is now around 2,435, which is 143 points (a bit over 5 percent) below where we are right now. I will start paying attention when the S&P drops to its 200-day moving average, although it would still be within the range of normal volatility. Therefore, it’s not something to necessarily worry about, but it would be the first step suggesting that a deeper pullback was in the cards.

We are not even close to that, of course. So, given the positive fundamentals and the market’s proven ability to recover from bad news, a bounce back is a more probable result than a bigger pullback. That is how I got to my conclusion in the interview.

What could change my mind?

Although I am reasonably confident in my conclusion, I have also thought through when I will start to consider the alternative. We need to assess, each step of the way, what could make us change our minds. For me, right now, it is the S&P dropping to its 200-day moving average.

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