The trading pattern that has dominated the markets for the past year could be breaking down—and that could spell opportunity for investors.
After a disappointing payrolls report on Friday morning, investors poured out of stocks and into the safety of bonds, a continuation of the "risk-on, risk-off" pattern that has come to characterize the post-financial-crisis markets. Depending on the economic news, the theory goes, investors either love stocks or hate them—even, seemingly, in the same week.
But while Friday appeared to be a classic "risk-off" day—the Dow dropped 62.29 points, or 0.5%—there are signs that the broader pattern of stocks moving in lockstep is beginning to wane, and that fundamentals are reasserting themselves.
Consider the most recent slide in the Standard & Poor's 500-stock index, which lasted from April 29 through June 15. That slump saw stocks drop for six weeks in a row—the longest rout since 2008—and seven out of eight. The 7.2% decline was the eighth of at least 5% since the market bottomed on March 9, 2009. That is the most such drops in the first 28 months of a bull market since the 1930s, according to InvesTech Research in Whitefish, Mont.
But the recent selloff was most notable for its gentleness. Despite a flare-up of Greece's debt crisis, a slowing U.S. economy and signs of a possible housing bubble in China, the S&P fell by an average of just 0.23% a day during the slump, the least of any of the eight recent dips. Meanwhile, the Chicago Board Options Exchange Volatility Index, known as the fear gauge, peaked at 22.7, only slightly higher than its 20-year average of 20.2. By contrast, the VIX topped 80 in 2008, and surged to 45.8 last year.
The VIX reflects the cost of buying options to protect a portfolio. Its modest rise indicates investors are less inclined to buy options as insurance against a drop in the market. "People saw how the market snapped back in 2010," says Kevin Kearns, senior derivative strategist at Loomis, Sayles & Co. in Boston. "They aren't willing to pay a significant amount for protection."
Likewise, "correlation," or the propensity of individual stocks to trade in lockstep with the S&P 500, rose no higher than 0.61 during the latest rout, much lower than the 0.81 registered in July 2010. (A correlation of 1.0 means that stocks move in perfect synch; a reading of minus-1.0 means they move in perfect opposition.) Correlations rise during selloffs as investors throw out the good with the bad. Lower correlations mean there is less fear. "After the seven previous drops, investors have become less susceptible to panic selling," says InvesTech Research President Jim Stack.
The lower correlations have meant that, unlike the 2010 swoon, some sectors have held up well this time. Investors could have made money by avoiding financials and energy, which lost 4.6% and 5.9%, respectively, and buying health care, utilities and staples, each of which returned more than 5%.
Professionals, in particular, appear less prone to selling pressures. While the percentage of bears outnumbered bulls by a 2-to-1 margin in the July 9 American Association of Individual Investors survey, there were nearly 50% more bulls than bears among advisers, according to the Investors Intelligence survey. In 2010, both showed investor sentiment plunging.
The difference in sentiment also was reflected in their trading. Retail investors withdrew about $26.7 billion from U.S. equity mutual funds in May and June, according to data from trade group Investment Company Institute, only slightly less than during the same period in 2010. Hedge funds and other professionals, meanwhile, cut their "short positions," or bets against the S&P 500, by 96% during the week of June 21.
"The shorts are getting out at the first sign of optimism," says Barry Ritholtz, director of equity research at FusionIQ in New York. "That's contributing to shallower drops."
Still, that doesn't mean investors should load up on risk now. Lower-quality stocks have been the best performers since March 2009, but the market appears to have begun favoring high-quality stocks, according to Greg Swenson, a senior analyst at Leuthold Group LLC. High-quality companies, defined as those with low leverage and stable profitability, gained 2.5% in the second quarter, compared with a 1.5% loss for low-quality stocks.
"You don't have to have a correction for high quality to outperform," Mr. Swenson says.
When should you dump stocks? Mr. Stack of InvesTech is watching the ISM manufacturing survey for a drop below 50, and is tracking the economically sensitive Dow Transportation Index, among others.
But with the June ISM rising to 55.3 and the Dow Transports closing at a record high on July 7, Mr. Stack is leaving his equity allocation above 90%, where it has been since May 2009. "It's best to give this bull market the benefit of the doubt," he says.(finance.yahoo.com)