WisdomTree

Market News

Is the Correction Over?

by Luciano Siracusano III, Chief Investment Strategist on October 27, 2015

Back on July 20, with U.S. stock indexes not far from their yearly highs, I said on CNBC that I expected the market to become choppier over the next three months. I pointed out that with the S&P 500 Index trading at nearly 19 times—and corporate earnings unlikely to advance in the second half of the year—the market would need to digest not just the slowdown in China but also the uncertainty that would accompany a pending Federal Reserve (Fed) rate hike, scheduled European elections and our own budget process and debt limit debate come this fall. Over the five days following July 20, the S&P 500 declined 3%. In a follow-up blog post, I elaborated on why I thought the August-to-October time frame was the most likely period for the U.S. stock market to correct.

When the 1,000-point sell-off in the Dow arrived a month later on August 24, not only had the correction cleared out excess investor exuberance, it showcased a selling frenzy that rivaled Wall Street’s worst days over the last two decades. The Volatility Index (VIX), which measures the level of fear in the market, catapulted to over 40 intra-day—only the eighth time period in the last 20 years it had done so. Two months after those August lows, the question now becomes, is the worst of the sell-off behind us? And if so, is there another leg up to this aging bull market?

Is the Correction Over?

On October 21, I said on CNBC that I now believed it was, provided that Congress votes without undue drama to pay its bills.

With weak third-quarter earnings now being reported, one could make a good case that the lows for the year have already printed—especially if one believes aggregate earnings on the S&P 500 will rebound in 2016, which I do. However, the market has one more hiccup to digest in 2015: a congressional vote to raise the Federal debt limit. The last time the debt ceiling became hostage to political brinksmanship, back in the summer of 2011, the market sold off nearly 20% and Standard & Poor’s downgraded the credit quality of the U.S. government. The debt limit was only raised after a tense round of high-stakes horse trading: more borrowing capacity in exchange for reductions in future spending. The uncertainty surrounding this outcome could yet unleash a new round of volatility into the system. But it would take a colossal act of legislative incompetence and political stupidity to allow the federal government to default on its debt, so I view the threat of actual default as minimal. This does not mean a deal will get done without some drama (watch for debt limit countdown clocks on cable). If the market sells off into the deadline, I would view that as a potential buying opportunity for investors with time horizons that extend at least a year into the future.

Spikes in the VIX Often Create Buying Opportunities

Over the past 20 years, spikes in the VIX have generally coincided with major market lows. This makes sense, as the VIX moves in the opposite direction of the S&P 500 when risk is being re-priced and stocks are typically being sold. More often than not, spikes in the VIX create buying opportunities for long-term investors who have the courage to buy into markets when others are selling. That may be hard to do in the moment, but the data suggests that investors have historically been rewarded for it. If we measure the total returns of the S&P 500 over the 12 months following each of the periodic VIX spikes over 40, we notice that the market was notably higher in six of the seven periods and that the average one-year return over all the periods was 21%.

VIX Intraday Spike Over 40

In seven of the last eight instances, the S&P 500 retested the VIX spike lows within four months of the first sell-off.1 The exception was the market rally and recovery after September 11, 2001. This means that investors typically had a second chance to increase or re-establish positions once that second retest of the initial panic lows had been successfully achieved. On September 29, 2015, the S&P 500 touched 1872 intra-day— about .3% above the August 24 intra-day low of 1867.

Conclusion

Short of a debt default, I don’t believe the 10% decline this summer will be the start of a new bear market. Although the market is currently trading at a forward price-to-earnings (P/E) ratio of 16—higher than its historic average—I believe the current mix of low interest rates, low unemployment, healthy consumer confidence and consistently strong consumer spending remains supportive of further market gains. The forces that have propelled U.S. equity gains these past five years—stock buybacks, dividend yield and dividend growth—remain in place, even in the face of current lackluster sales and earnings growth.
 
 
Unless otherwise noted, data source is Bloomberg.
 
 
 
 

1In March of 2009, the S&P 500 unsuccessfully tested the October 2008 low and fell another 10%. However, over the subsequent seven months, the S&P 500 Index nevertheless was able to rally and close 26% above the October 2008 lows.

Click to see more articles from this category