A Random Reversion on Wall Street

Fri, Feb 2, 2018 - 3:20pm

What goes up, must come down. And it was finally the stock market’s turn to take some profits aside. Friday’s 2.13% decline in the S&P 500 was the bookend to a week’s drop of 3.86% - all while the majority of companies this week produced positive earnings and sales surprises. The correction this week served as a bearish engulfing pattern on the weekly chart, a reversal pattern of some renown.

No news event, no central bank catalyst, and no bubble bursting caused investors to sell this week. Merely, selling begot selling. Post the election in 2016, we haven’t had a 3% drawdown in the S&P 500. Looking at the counter, it has been essentially 311 trading days from the last 3% drawdown. So reversion to the mean is the name of the game.

The news this week could have fueled the advance further but it did not. Of the 251 companies that have reported their fourth quarter 2017 earnings, 80% have beaten sales estimates and 75% have beat on earnings estimates. The number of companies reporting sales surprises is record-setting with the 5-year average at 56%. The materials sector has had the largest upside surprise from estimates, at around 11%, while energy has had the largest downside difference between actual and estimated earnings, at -12%. The last report I read from FACTSET showed the earnings growth rate for Q4 stands at 13.4%, up from the estimated rate of 11% on Dec 31. Analysts are projecting S&P 500 earnings growth of 16.8% for the full 2018 year; that’s up from 12% at the beginning of the year as more companies have increased their guidance as a result of the reduction in corporate taxes.

So earnings are strong to very strong just as Seth Davis described his portfolio in the movie Boiler Room (2000): “Investors are selling stocks because earnings were better than expected.” Would make zero sense this week but that’s essentially what happened. Stock valuations are high, and it was time that a pause takes place in an otherwise uninterrupted advance in stocks.

The US stock market is mean reverting. The trend accelerated higher in January and the release valve was needed. It’s here now. With the kind of momentum we’ve seen, it’s very difficult to say that the bullish trend from November 2016 can end this immediately. A bearish reversal is formed when the bulls fail to rally prices to a higher high in the month to come. Calling a top here would be premature. In the article, Records Were Made to Be Broken, Chris Puplava showed in a study he did that the average returns for the S&P 500 from 1928 to today after the weekly relative strength indicator hit 80 were 4.23%, 8.46%, and 13.63% looking at forward returns 3, 6, and 12-months after the event. Momentum like we’ve had, without the parabolic move, usually paints a positive outlook for returns in the near future. So as we revert, don’t hit the red alert.

That said, certain stocks are trading in parabolic moves, many standard deviations away from their 200-day moving average. In such cases, it would be hard-pressed to say such moves could be prolonged so take precautions to set stop losses. Setting stop losses is just good unemotional risk management. As Steve Nison, a valued technician who formalized Japanese Candlesticks in the US through his books says, “all long-term trends begin as short-term moves”. The crystal ball is cloudy. Though the economy is strong, and Treasury yields have been rising on those terms, nobody knows at which point the top will show up.

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