Has the bell at the top rung?

After October’s stock market correction, investors are pondering whether to sell, shift into defensive stocks, or do nothing.

Pudd’nhead Wilson was right! October has proved to be a notoriously dangerous month for stocks.

When I wrote at the end of September that the ninth month is – statistically – a worse month for stocks than the tenth, I was tempting the gods, wasn’t I?

October, the month of Halloween, needs to be feared. It’s done well to reclaim its reputation as the market’s bogeyman.

All major stock markets have suffered significant losses last month.

To paraphrase Leo Tolstoy, all rising stock markets resemble one another, each falling stock market is falling for its own reasons.

UK markets are depressed because of concerns about Brexit…

A sell-off in Big Tech stocks is dragging down the US markets…

The Italian government’s collision with Brussels is worrying European investors…

China is weighed down by escalating trade tensions with the US…

And emerging markets struggle with a strong dollar.

Investors are faced with a choice. Do they ride out this storm, move out of growth stocks and into defensive stocks, or do they sell out of the market before the bear returns?

Three scenarios

Wall Street Journal columnist James Mackintosh notes that investors are busy figuring out which of the following three scenarios applies to the stock market today.

The stock sell-off we’re seeing at the moment could be “a healthy correction in a bull market with further to run” (scenario 1).

It’s “a reset lower in belated recognition of this year’s geopolitical risks” (scenario 2).

Or it’s “the start of a new bear market ahead of a recession as soon as next year” (scenario 3).

Let’s have a look at those scenarios and what evidence there is to back them up.

Tech stock valuations had been getting a little insane. Amazon went from a market cap of $600bn at the start of the year to $1trn at the start of September.

Other “superstars” like Apple, Netflix, Facebook, and Alphabet (Google) also added hundreds of billions to their market cap this year after reporting positive figures.

With these Big Tech stocks overpriced, it’s not strange they’ve had to hand back most of these gains now that they’re reporting less than stellar results.

As far as Mackintosh is concerned, that’s all this is:

“I’m inclined toward the view that this is a healthy correction, as I started out thinking that this year’s rapid rise in the FANGs and other acronym stocks was overdone.

“A rotation away from overpriced tech into cheaper companies makes sense and is still under way, as Monday’s 6% drop in Amazon shares showed. It doesn’t mean the economy is weak.”

Then there’s door number 2, where investors aren’t quite ready to sell out of the market yet but they are growing more pessimistic.

At the very least, they’re taking precautions by rebalancing their portfolios. They’re moving out of growth stocks and towards defensive stocks.

If we look at the S&P 500, we see a definite shift from offence to defence.

Sectors exposed to economic growth like technology, energy, industrials, materials, consumer discretionary and communication services are all down more than 10% since 3 October.

On the other hand, sectors of the defensive genre like utilities, consumer staples, and property have seen slight gains.

Lastly, there’s the possibility that the bull after a nine-and-a-half year run has finally reached the end of the road.

Investors could decide this is as good as it gets, and the sell-off becomes self-fulfilling.

Scouring the history books for an answer, Ritholtz Wealth Management’s Ben Carlson writes on his blog A Wealth of Common Sense how markets have historically reacted to a 10% correction:

44.7% of the time they didn’t fall any further than 15%

12.8% of the time they didn’t fall any further than 20%

17.0% of the time they fell between 20% and 30%

10.6% of the time they fell between 30% and 40%

8.5% of the time they fell between 40% and 50%

6.4% of the time they fell more than 50%

Note: we speak of a bear market when stocks fall 20% or more.

The good news is 57.5% of the time a 10% correction didn’t lead in a bear market.

The bad news is that a still uncomfortably high 42.5% of the time a 10% correction was just the start of something far worse.

The bell at the top

“They don’t ring a bell at the top of the market,” a famous Wall Street saying goes.

After a promising start, a scare in February, and another decent run from April until September, markets have now lost all that was earned this year.

In fact, the Dow Jones and the S&P are negative for the year. Investors have gained 10 months in age but they have gained nothing in the markets. They are now poorer than they started the year, not richer.

Optimists will point to February, when the markets corrected but quickly rebounded, and say the markets recovered just fine. But there are clues that October isn’t February…

Says Bloomberg’s Arie Shapira:

“The selling that we’ve experienced [in October] appears more orderly than what we saw during the early Feb. machine-driven breakdown, which lasted just over a week and was more volatility-driven than anything else.

“This time around, we have a much larger laundry list of macro worries from a global growth slowdown to the deteriorating situation with the trade war … that has led to a giant rotation out of growth stocks and the bull market winners and into value and any sector deemed defensive.”

There is another explanation. The market was leaning too heavily on just a handful of stocks.

By mid-July, Alphabet, Amazon, Apple, Facebook, Microsoft and Netflix accounted for 99% of the S&P’s total year-to-date gains…

The tech superstars carried the team for a while, but they are no longer able to meet higher and higher expectations.

Wall Street has set the bar too high. One by one, they’re falling short.

Amazon and Netflix are down more than 23% since the start of last month. Facebook and Alphabet couldn’t satisfy investors either as their shares tumbled 14%.

All eyes are now on Apple to save the day…

“If Apple disappoints in any way, or gets swept up in the wave of tech selling thereafter, then I’d imagine a consensus ‘This Is the Top’ opinion forming for the broader market,” writes Shapira.

“If that scenario ends up playing out, then Apple passing the $1 trillion mark and the talk of who would be next (Amazon or Microsoft, now at ~$750 billion and ~$800 billion, respectively) will forever be remembered as perhaps the most momentous sign of the top to this nine-and-a-half year bull market.”

In hindsight, Apple becoming the first 13-figure company in history may have been as close as it gets to a bell ringing at the top.

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