While we can’t make a prediction with 100% certainty, we can assign probabilities to the next trend for the U.S. stock markets. The major U.S. market indexes (Dow Jones 30, S&P 500 and NASDAQ Composite) all reached new highs for the rally on or about April 28. Additionally, technical indicators of the market’s underlying health were all strongly positive as well. The correction that has ensued since April 28 has erased between 9% and 11% of the averages’ value. In a less tumultuous time, this kind of performance would be seen as a normal correction and not the start of a new bear market.
There are two root causes for the stock markets’ performance since the end of April:
- The U.S. market had not experienced a 10% correction since the start of the new uptrend in March of 2009. We saw two corrections (in June 2009 and January 2010) that declined less than 9% on both occasions. The selling was less intense than of late and the markets quickly rebounded from their lows. This correction probably marks the end of the first stage of the new bull market, where nearly all stocks — regardless of size or quality — go up. The second stage will see more selectivity among investors and moderating returns compared to the past 14 months.
- The Greek debt crisis and fallout among other members of the Euro currency zone has reminded investors that risk still exists in the debt markets. The U.S. experienced a private debt crisis in 2007-2008 when the mortgage market imploded and caused several large financial institutions to fail or need significant government help to stay afloat. The Euro crisis is a government debt issue with Greece being unable to sell new debt without the explicit guarantee of the European Central Bank (akin to the Federal Reserve). This rescue package was announced two weeks ago but has yet to allay fears that more trouble may be brewing for Greece, Portugal, Spain and Italy. We think the rescue package has been effective by bringing down interest rates for all four countries though significant work remains to be done to reduce their budget deficits without causing major recessions in those countries. (This is something all governments need to do!)
A silver lining to the decline of the past few weeks is oil prices have declined from almost $90 to $70 per barrel. Look for lower gas prices as a result. Interest rates have also declined as investors have fled to Treasuries as a safe haven. Mortgage rates will likely decline as well. Finally, the U.S. economy may have finally entered a durable recovery and this momentum is hard to reverse in a short period of time.
Investors can expect that volatility could remain elevated over the next few weeks or months as more news coming out of Europe could influence opinions about the impact on U.S. economic growth.
George Farra is co-founder and principal of the investment firm Woodley Farra Manion Portfolio Management in Indianapolis.