Stock Pullback: Assessing The Damage

Escalator up, elevator down? The forces of gravity finally returned to the U.S. stock market, at least for a couple of days. After rising by +19% on the S&P 500 and +26% on the NASDAQ 100 in just over two months since June 26, both headline benchmark indices moved sharply to the downside on Thursday and Friday of last week. What measurable damage, if any, has this recent pullback in stock prices inflicted? And what should investors reasonably expect from here?

Flash Correction. Within eight trading hours from Thursday’s open through mid-morning Friday, the S&P 500 dropped by more than -6%, while the tech heavy NASDAQ 100 dipped briefly into correction territory in falling by more than -10%. Both indices spent the rest of the trading day on Friday clawing their way back up the elevator chute, but still ended lower between -4% to -7% over the two day period by Friday’s close.

What now? Amid the first patch of downside pressure in more than two months, what should stock investors reasonably expect as we enter the upcoming holiday shortened trading week?

1. ‘Tis but a scratch. It is first important to put the recent stock market correction into context. Yes, the stock market pullback on Thursday and Friday was sharp. But so too was the stock market ascent that preceded it. So while both the S&P 500 and Nasdaq were down quite a bit, at their Friday intraday lows they had still only fallen back to levels at which they were trading just two weeks ago. And Friday’s closing levels would have represented new all-time highs for either index at the start of the previous week on August 24. In other words, the end of week pullback has been effectively nothing so far.

2. Stocks love Mondays. A quirk of the post COVID crash trading experience will be worth watching as the new trading week gets underway. Consider the following average rates of return on the S&P 500 by weekday since March 26.

Monday: +0.98%

Tuesday: +0.06%

Wednesday: +0.37%

Thursday: -0.22%

Friday: +0.08%

Put simply, virtually all of the stock market gains since the late March lows have taken place on Mondays. The S&P 500 Index is up over +30% since March 26. But if one were to take away Mondays, the S&P 500 would be up less than +5% and would be lower since June 5. Exactly why stocks have been up so strongly on Monday and effectively flat for the remainder of the trading week (average +0.07% daily return from Tuesday to Friday) is just one of the many anomalies that can surface during periods of aggressive Fed quantitative easing through daily Treasury purchases. For example, back in 2013 and 2014 during the Fed’s QE3 program, the key trading day of the week was Tuesday.

Will it matter that stocks won’t trade on Monday because of the Labor Day holiday? Perhaps. But for the trading week of May 25 when the market was closed on Monday for the Memorial Day holiday, stocks advanced by +1.23% to start the week on Tuesday, May 26. This “Monday effect” alone may be enough to stem if not completely arrest any further decline in the immediate term.

3. Still frothy. Even if stocks bounce on Tuesday to open the trading week, it still does not take away the fundamental problem still plaguing both the S&P 500 and the NASDAQ 100. Both are still trading at historically extreme valuations.

For example, the S&P 500 Index was trading at 40 times estimated 2020 earnings at Wednesday’s all-time highs. Following the two-day pullback to close out last week, the S&P 500 is still trading at a historically rich 38.2 times estimated 2020 earnings. By comparison, the historical average multiple for the S&P 500 Index is 16.4 times earnings.

Both the S&P 500 and the NASDAQ 100 are still trading well above their long-term moving average trendlines. For the S&P 500, it still has room to fall further to the downside by -4% to its medium-term 50-day, -10% to its long-term 200-day, and -12% to its ultra long-term 400-day moving averages and its uptrend would still remain intact.

As for the NASDAQ 100, it is worth noting that it is still at its highest premiums relative to its 200-day and 400-day moving averages since early 2000 when the tech bubble was peaking. In other words, the NASDAQ 100 is still blisteringly hot even after the fleeting correction late last week. And the tech heavy benchmark could fall another -5% to its 50-day, -19% to its 200-day, and -27% to its 400-day moving averages and the uptrend would still be maintained.

Such is the risk associated with expensive and high-flying markets. The further they get ahead of themselves, the more dramatic the corrections may be in simply reverting back to the long-term mean price trend.

4. Still concentrated. Another problem that continues to plague the U.S. stock market is the reliance on a select few mega cap…

Read More: Stock Pullback: Assessing The Damage

Notify of
Inline Feedbacks
View all comments

Get more stuff like this
in your inbox

Subscribe to our mailing list and get interesting stuff and updates to your email inbox.

Thank you for subscribing.

Something went wrong.