After a sterling first quarter, stocks went into retreat during the first two sessions of the second quarter. After 5 straight up months without a correction exceeding 3%, some profit taking was due. Strong economic data led to a rise in the yield of 10-year Treasuries to the top end of their range. The yield in early morning hours of 4.37% is the highest since the start of November.
Stocks have been way overbought. What does that mean? In simple terms, even within the context of a bull market, stocks can go up too far too fast. One indictor traders watch is a 200-day trend line. For individual stocks, that normally slopes upwards in good times along with earnings and rising investor enthusiasm. But at times, the enthusiasm exceeds reality. Simply said, stocks get ahead of themselves. Prices reach far above trendlines. When that happens, a correction can’t be far away. Almost anything can trigger that. As I have been noting, corporations that report earnings on calendar quarters (that’s most of them) cannot be active buyers of their own stock close to the reporting date. While each company has its own rules governing when they have to stay out of the market, once the quarter is complete, even if the full results are not yet available internally, they all must stop until after results are reported. That removes an important tailwind, at least for the next several weeks.
Earlier this week economic data for March began to be reported. So far, virtually all the reports show economic strength. Perhaps too much strength for those expecting the Fed to start cutting rates by June. Fed Chair Jerome Powell is scheduled to speak today and could express his view. But whatever he says, June is still a long way off. If economic data is running too hot or services inflation remains sticky, a June cut won’t become likely. One can argue whether that matters or not. Stronger growth means better earnings even if rates stay higher a bit longer. Equity investors don’t want to see 10-year Treasury yields return to 5% where they reached last October, but 5% is still a long way from 4.37% where yields sit this morning.
Thus, what most probably is happening now is a start to a correction of an overbought condition. How long must such a correct endure? It could end real soon never reaching 5% or it could last several weeks reaching 10% or even a bit more. What might cause a worst-case outcome? I list a few factors below.
1. Worse than expected inflation data when the CPI report comes out April 10.
2. Wage increases for March that increase inflation worries when the March employment report is released this Friday.
3. Tepid earnings guidance as companies release first quarter results.
4. A further spike in the 10-year Treasury yield to 4.5% or higher.
5. Any unexpected Black Swan event.
All of the above are not likely but any one of them could accelerate profit taking. When stocks are overbought, traders hold on until they see a change in momentum. Another day like the last two would definitely seal the notion that a correction is at hand. Traders will accelerate selling, short the market, or use options to protect against further downside. How can the skies seem so sunny one week and so ominous the next? It’s no different than the weather. But as long as the long-term trend is pointed higher, there is little reason to be overly worried. Rather, this is a good time to create a shopping list of companies you missed on the way up and want to own. Set a price target. No need to get too aggressive if this week’s dip turns into a full-fledged correction. But nibbling once a price target is reached makes sense.
I don’t want to suggest that the only stocks to watch are those that led the rally of the last nine months. If no recession occurs, you will see the economic fortunes of many cyclical companies improve over the next several quarters. Valuation matters. While momentum players have been chasing the same group of stocks over the past several months, that may change going forward. AI has added to the growth prospects of many tech companies, particularly key semiconductor companies. But there is value in many of the names left behind. Businesses that have begun to flourish include companies involved with fortifying the electric grid, building new infrastructure and benefiting from the rising cost of insurance. Their stocks, for the most part, moved too far too fast and need to correct. Consider buying those dips.
But also remember two other laws of nature. First, for every action, there will be an equal and opposite reaction. Yesterday, CMS, which sets Medicare rates, released allowable increases for 2025 well below what Wall Street had expected, and health insurer stocks cratered. But don’t forget Newton’s Law. If prices are to be held down, then the companies will likely reduce benefits to compensate or increase the rate of non-Medicare products. Good companies adapt to a changing rule book. Those free eyeglasses or gym memberships might be gone soon.
Second, listen to the words but take them with a grain of salt, especially when spoken by a politician. Biden asked Congress for $80 billion to fund a massive expansion of the IRS in order to audit rich fat cats and regain hundreds of billions of dollars of unreported tax obligations. The goal in the first year was to hire 3,700 agents. Over the first six months, it has hired 34. Moreover, while promising that the audit expansion would only impact those earning $400,000 or more, so far the vast majority of the increases in audits have been for those earning less than $200,000.
The IRS is offering to pay $125,000 plus plush Federal benefits for these new auditors. These new hires are supposed to go after the fat cats sitting across the table surrounded by their sophisticated lawyers and accountants. For $125,000 the government isn’t getting a senior partner from a big accounting firm. They are getting someone who knows he or she is likely to be outgunned in such a scenario. No wonder it can’t hire more than 34 candidates. This whole program was illogical from the start. The list of falsehoods goes on. One of the reasons that EV sales have slowed is that qualifying for the supposed tax credits of $7,500 isn’t quite as easy as it sounded if battery or car components were made in the wrong country, for instance. EVs make little economic sense without the credits.
It’s election season, so the government is considering more handouts despite huge deficits. One example is the earned income tax credit. In theory, it’s a good idea to encourage Americans to work. But now Congress is being asked to allow the credits for people with no income as long as they can show that they did work in the recent past. A tax credit against no income? Makes no sense. Hopefully, it won’t become law. Fortunately, this and other nonsensical asks in campaign season require 60 votes in the Senate and a majority in the House. Since Republicans hold a majority in the House and can’t agree on anything, the likelihood of any new significant legislation this year is close to zero. Voters in November will get their chance to continue this farce or not.
Back to markets, I often note that facts dictate long-term outcomes while momentum and short-term emotions rule the short-term. Momentum and psychology can change on a dime. No one I know can tell you when they are at a peak or valley. Market tops tend to roll over while bottoms are usually V-shaped, easier to spot. Traders themselves often get whipsawed. The reason you witness sharp one-day rallies in bear markets or corrections, or days like yesterday is that day traders need to cover shorts if they are on the wrong side of a trade. That’s where my simplistic two-day rule comes into play. Don’t let one-day countermoves fool you. Short-covering accentuates the damage. But traders react quickly. If is still strong selling by the end of the second day (or strong buying at a market bottom), then it’s time to take notice.
Yesterday’s drop was accentuated by one Dow stock. From 10am to the close at 4, the market moved sideways. So, I am reluctant to say a full-blown correction is at hand. But if today is a nasty session and ends near its low, I would be more convinced. Whatever happens, a correction is both overdue and healthy. Fundamentally, economic factors support a move toward higher prices over the medium or long-term.
Today, Eddie Murphy is 63. Alec Baldwin turns 66. Jane Goodall is 90.
James M. Meyer, CFA 610-260-2220