Bloomberg - What I Suspect and Fear for the Stock Markets

by Barry Ritholz
October 13, 2014

Here we are, 10-plus months into the year, and we have nothing to show for it.

At least, that is the case if we measure our progress by the gains (or losses) of the Dow Jones Industrial Average. The index is now unchanged for the year after last week's losses. The previously one-direction market has suddenly recalled what volatility looks like, having for the most part forgotten.

Yes, stocks go up AND down.

At the beginning of the fourth quarter, the Standard & Poor's 500 Index was up about 7 percent for the year; those gains have now been cut by more than half. The Russell 2000 small-cap index was already down almost 5 percent, and the past few weeks have added to the red. The Nasdaq 100 is still positive on the year, but has given back some of its gains.

I can't tell you what will happen in the coming weeks or months, nor can I tell you what to do, not knowing your time horizon, risk tolerance and client base. I can, however, bring to your attention some interesting data points you may not have been aware of:

• Since 1928, markets have averaged about three 5 percent corrections each calendar year;

• U.S. stock markets haven't experienced a 10 percent correction since October 2011;

• Big-cap indexes (S&P 500 and the Dow) are within 5 percent of their all-time highs;

• Small-cap stocks have fallen below their 200-day moving average for the first time since November 2012;

• Half of Nasdaq stocks are down 20 percent from their one-year highs, meaning they are already in a bear market;

• S&P 500 earnings estimates are fully valued: Trailing 12-month price-earnings ratios are a pricey 18.6; forward P/E is an average of 15.85 (according to Birinyi Associates);

• The S&P 500 has fallen to just about its 200-day moving average;

• The yield on the 10-year Treasury bond is now 2.28 percent, a decline of more than 30 basis points in the past month.

Then there is the concern about October as the worst month of the year for the stock market. The month has a bad reputation, likely due to a few outlying events that occurred in the past: The 1987 crash was less than 30 years ago, and even those traders who weren't yet born are familiar with the details of that particular episode. (I always recommend Tim Metz’s "Black Monday" for anyone who wants to understand what happened).

The 1929 crash (Oct. 29, "Black Tuesday”) also occurred in this month. The Great Depression -- the worst economic crisis in U.S. history -- followed.

Is it any wonder traders can be superstitious about October?

Ned Davis Research noted that of the “69 major trend changes since 1900, nine took place in October.” Mark Hulbert observes that while this “is higher than the monthly average of 5.75, October’s total is neither statistically significant nor unique.”

As the "Stock Traders Almanac" is fond of pointing out, the six months that follow October are on average the best half of the year for equities. Whether that is because October affords a better entry price or is due to some other factor is both hotly debated and unresolved.

The key question for investors is what to do in the face of this data. The simple truth is that we don't know whether this is going to be a run-of-the-mill 5 percent pullback, a deeper 10 percent correction, or a full-blown bear market. I hope for the middle outcome, while suspecting and fearing the third -- but that's only a wild guess.

I suspect most investors will undertake one of three options:

Benign neglect: They will ignore all of the goings on because they are autopilot investors. Their approach is to ride it out, making few moves other than regular portfolio rebalancing. These folks tend to do well over the long haul, but have little to talk about at cocktail parties.

Over-reaction: These traders digest a massive amount of information via the media. They will obsessively consume as much news as possible before undertaking a series of radical changes in their holdings. Their performance may not be optimal, but they are great for anyone who toils in the world of commission-based compensation.

Cautious contemplation: These are the investors who approach markets with a zen-like calm. They spend much of their time carefully thinking about the impact of their own actions on their returns. They are, for the most part, sociopaths who can disengage their emotions from their trading.

What kind of trader are you?