How Long Will Correction Last? - Tactical Trading

To answer this question, it would help to recap how this meltdown unfolded and then we can make a good estimation of what it means for the next 2-3 months.

I will describe a shift in posture on the economy and the market that I experienced between Friday and Tuesday -- and that I think also happened for large institutional investors (the ones who helped the meltdown happen).

I have been very bullish on stocks for two years. But since May, I have been in the "sideways to lower" camp on the broad market as we evaluated lots of "slowdown" data in a seasonally weak period for equities. That necessitated smart stock-picking with a focus on strong earnings as essential to investment survival.

And I started to grow more cautious after hearing Federal Reserve Chairman Bernanke speak in June. He has access to more and better data about the economy than anyone. He also has a small army (a few dozen anyway) of economists and researchers led by David Stockton helping compile and analyze that data.

When Bernanke sounded more cautious in his June statement and press conference, I wrote "Bernanke Worried = Rotate Defensive."

A week later I summed up my cautious thoughts in "Summer Pullback Over? Not So Fast."

Then came the abysmal June jobs report on July 8, for which I wrote "Slowdown Looks Entrenched."

But I was still bullish on stocks because of strong demand from Emerging Markets and the strong trends in US corporate profits that derived over 40% of their earnings from it. The debt worries in Europe and US were contained it seemed and the market continued to shake them off.

GDP vs. Corporate Profits

Then came last week's awful GDP revisions, resulting in first half growth of only 0.8%. When combined with weakening manufacturing and consumer spending/income data for the past two months, I immediately adjusted my recession probability over the weekend from 15% to 45%.

On Tuesday when the S&P touched the March lows, I said that technically the market was broken and we were going lower.

On Wednesday, I wrote "Look Out Below!" and described why the next target was 1,200. Here's what I wrote the day before the 4.8% drop in the S&P from 1,260 to 1,200...

"Let me reiterate the bearish fundamental case against stocks that I have been writing about since we got the awful GDP data last Friday...

Major Premise: US corporate earnings are strong because of strong Emerging Markets demand, not domestic growth and consumption.

Minor Premise: First half GDP, June and July manufacturing data, and this week's eroding ISM outlook are trending back toward recession territory.

Conclusion: If Emerging Market economies (China, Brazil, India, etc.) slow down fast, earnings will fall as domestic demand will not sustain them.

The next logical conclusion is that stocks will fall in advance of this possibility because portfolio managers are looking at the next 2-3 quarters of earnings to justify their investment picks, and the growth just won't be there in their projections.The market will price in a dark year ahead for the economy and stocks in the next few months."

Here's Why the Meltdown Happened

Once equity portfolio managers, and institutional investors in aggregate, absorbed the huge disconnect between GDP and corporate profits, they suddenly had to change their outlook for equities.

Why? Because they had to figure that if domestic demand was that weak -- which the labor market had been trying to tell us all along -- and if there was any slowdown in Emerging Markets, earnings were sure to fall from their record pace and trajectory.

This meant forecasts for growth and earnings were going to be adjusted lower for the next two quarters at least. And when in this period of doubt, you lighten your load and get some cash.

Portfolio managers look forward. And they use estimates about growth and earnings to model their risk/reward. Without domestic demand and a consumer taking it on his chin in the labor market, they had to reason that earnings and thus market levels were unsustainable.

And this was especially true with a red-hot Chinese economy trying to cool its overheating engines of global growth. All optimistic earnings projections for next year had to be scrapped.

The earnings estimate revisions (EER) -- our bread and butter research at Zacks -- have yet to be moved downward to reflect this new outlook. But they are coming and we will likely hear them in droves after Labor Day.

Are the downward EER all priced in? It's hard to say. September will continue to as interesting as August and this will form the logic of my forecast until November.

Self-Reinforcing Feedback Loop

A single-day 5% market drop has its own hyperactive mix of panic, margin calls, and self-fulfilling prophecy, especially after a week of selling that just needed a big one-day push to be called "a correction" (down 10%).

And macroeconomic dynamics also act in feedback loops with jobs and growth and stocks all impacting each other -- especially where confidence is the most crucial of currencies.

So while I thought the S&P was headed to 1,200 as the big boys of markets priced in a higher chance of recession, I didn't think it would happen the next day -- and all at once!

Now that this sort of damage is done, we are in a waiting game. What are we waiting for? Visibility on earnings, growth, jobs, and potential government stimulus.

This isn't 2008 all over again (though it may have felt that way on Thursday). But it does change the investment landscape for the next few months.

My bet is that the bull market resumes in the fourth quarter. Let's quickly look at the things we are waiting for and get an idea of how to play the game.

QE Next and Next FED Forecasts

As I've been writing about for months, "QE Next" is irrelevant. I mean if QE2 was pushing on a string, what traction do we possibly gain with more extraordinary monetary stimulus?

The good news is that we know interest rates will remain accommodative for an even longer extended period. After the Fed meeting August 9, I am looking forward to the Fed's economic forecasts.

These will guide policy in Washington, hopefully. Yes, it seems that any fiscal stimulus is off-the-table after the debt drama, which will only serve to feed election issues for the next 15 months.

But the tax and spend debates may get shelved for a time this fall in favor of the jobs debate. We had some encouraging jobs data Friday morning, yet it's still not where we need to be and once Congress gets more education about where the economy is headed, they should align for some kind of fiscal stimulus.

Remember, we still don't have the number one creator of jobs in a recovery humming yet: construction and housing. And with our manufacturing jobs drifting overseas, there are more structural impediments to growth than cyclical ones.

What Has to Happen to Prevent Another 2008

And actually, the big central banks of the world -- primarily the Fed and ECB -- may be busy watching a bigger problem. If markets continue to melt down, they could have another liquidity and solvency crisis on their hands. In fact, they are probably already worried about it.

Why? Because financial markets are still a little fragile from the last crisis and even just a sneeze that sounds like a potential case of the credit flu could cause further contagion and contamination fears that spiral.

We will likely hear lots of perma-bears coming out to tell us how unsustainable the fiat currency system is and why we should only buy gold. In any case, the Fed and ECB will be ready with extraordinary liquidity measures to prevent any possible Lehman disasters.

Confidence and the Consumer

In my bullish note last month, The Seven C's of Recovery Optimism, I listed these as the number 6 and 7 driving forces. Time for an update as both are now sorely tarnished.

Confidence: Corporations have always been somewhat cautious as they hoard their cash; now investors are. Restoring confidence to markets is key. The weak ISM data was an early warning that CEOs might be looking at the economy as Bernanke did in June and saying "Let's not buy that right now."

Consumer: Debt drama did damage; now the "jobs-stocks-growth" feedback loop is weighing on psychology and sentiment. When people you know are still looking for full-time work after a year of unemployment, it sort of affects your spending plans.

My Forecast to November

I think the highest-probability scenario is a "wait and see" by institutional investors. That means to me that the S&P will range trade between 1150 and 1250 for the next 3 months, in waves of pessimism and optimism, until more visibility on GDP, jobs, cap ex, manufacturing, and corporate earnings rolls in.

Remember, this is going to get worse before it gets better. The downward earnings estimate revisions have not yet begun to roll in.

And while we want to believe in some good news, there is likely more bad news to come in the form of bank and country downgrades, hedge fund implosions, and margin calls in commodities. These will all be next week's headlines.

So, your focus needs to be on raising cash during rallies and careful stock-picking with stocks I call "earnings machines." For example, one of my favorite industrial names, Cummins (CMI) held up pretty good yesterday versus the rest of the market by closing above its June lows.

See how I play sell-offs on favorite names when they go on sale by using naked puts. I will be looking for opportunities to play energy names like Suncor (SU) and CVR Energy (CVI), tech names like Apple (AAPL) and IBM (IBM), and agriculture names like CNH Global (CNH) and Potash (POT) when I see the irresistable combination of oversold stock prices and high put premiums.

What are the chances that this advance "pricing-in of the recession" heats up and we dip below S&P 1,100? I'll say about 40%, right around where I think the probability is for an actual recession.

Use my probabilities as a rough guide and trade your own view accordingly. Many strategists from major investment houses, managing trillions of dollars in aggregate, have similar projections.

The hard part is that on big sell-off days, they look like they are more scared than they really are.

Kevin Cook is a Senior Stock Strategist with Zacks.com
 
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