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Like most stock market corrections that come out of nowhere, they don't take their time inflicting the damage.
The express elevator going down to maximum pain only stops at a few floors to let well-prepared investors off.
The rest are found selling in a panic near the bottom. This October correction has been no different and now it's time to sift through the wreckage and see if it's safe to buy yet.
In the video that accompanies this article, I take a look at 3 of my favorite indicators for signaling extremes in pessimism that usually mark a near-term capitulation.
The 3 indicators are...
The S&P 500 Percent of Stocks Above Their 200-Day
The Total Put-Call Ratio
The S&P 1500 New Highs-New Lows Percent Index
I look at 5-year charts of all three so you can see a good comparison to prior peaks of pessimism, especially those during the sideways markets of 2015-16 where we went through a six-quarter earnings recession.
I also explain the quantitative logic of institutional investors who use some variation of the Equity Risk Premium (ERP) model to value equities as interest rates rise and growth slows from its torrid pace.
Macro Angst and the ERP Solution
So let's talk about what has some investors getting "less bold" about the late-cycle bull market -- and thus less apt to buy this correction aggressively -- as if the top is in and we go sideways for 6-12 months (just like 2015-16) unless/until earnings stage another surge.
First, let's look at EPS growth projections. This is an update of Sheraz's chart I've been showing you all year as it implies "peak growth" and "as good as it gets" conclusions...
The "half glass" debate investors will continue to have is whether we focus on 2019 still offering y-o-y growth on top of "impossible" comparables from Q1 and Q2 2018 (half full) or we focus on steep declines in the rate of growth that could be foreshadowing a boom gone bust (half empty).
Those bears at Morgan Stanley, led by chief investment officer Mike Wilson, are definitely still focused on half empty. That's what I talked about on TDAmeritrade-TV on Tuesday using this table which I will explain in detail...
Recall that Equity Risk Premium is a measure of how much extra investors want to be paid over the risk-free rate. For example, if the 10-year bond is at 3%, investors may want to be paid double that -- 600 basis points, or 6% -- another 300 basis points more to justify owning equities.
The way that you calculate and use this data involves only a few simple steps...
1) First, flip the P/E of the S&P 500 into its "earnings yield" so you have an apples-to-apples basis against the bond. This table uses the consensus estimate for 2019 of $174 EPS. At S&P 2800, that's a P/E of 16X. Flipped into its earnings yield, we get 174/2800 = 0.062, or 6.2%.
2) 6.2% sounds like a great return from stocks. Alas, intelligent investors subtract the risk-free rate so they know how much better they are actually doing for taking all the extra risk of stocks. 6.2% minus 3% (assumed 10-yr yield) leaves 320 basis points.
3) Using the right side of the Morgan Stanley table, we can assume how different institutional investors who have a choice of various ERPs (equity risk premiums) might think and allocate. If an investor wants only 300 basis points premium over the 3% risk-free rate, then he calls S&P 2906 "fair value" and would be a buyer below there.
4) What if we have a conservative investor who wants 350 basis points of premium over a projected 3.25% 10-year? Now you are talking 675 basis points. Back that into our equation and you get a much lower S&P: 174/.0675 = 2578 (roughly in line with their 2583 in table).
As you can read at the bottom of the tables, Morgan Stanley strategists believe the S&P 500 will be stuck in this 2,600 to 2,900 range for a while as the 10-year ranges 3-3.25% and investors want 300-350 bps cushion.
Which is really this "code" for their hedge fund clients: "We are probably going to S&P 2500, where we will gladly buy it. But not here, not now."
Gaming the Correction, Ignoring the Crash Theories
I put this analysis together last week and presented it on TD-Ameritrade TV on October 16, a day when the S&P 500 had a big rally back above 2800.
And I convinced myself that Mike Wilson and his team were really on to something about the new risks in this market with "peak growth" ideas and EPS estimates too high at $174.
So, on October 19, I set a minimum correction target for the Nasdaq 100 (NDX) to fill the May 7 gap at 6770. My worst-case scenario was just under 6600. To capture that move, on Monday we bought the ProShares UltraPro Short QQQ 3X Bear ETF (SQQQ - Free Report) when the NDX was around 7150.
On Wednesday the 24th, the NDX dropped to 6777, about a 5% downdraft which handed us 15% open gains in SQQQ. But those gains are hard to capture unless you grab them on the big days where the market closes red. That's why targets and plans are so vital.
I also told my followers it's safe to buy down there as long as Apple (AAPL - Free Report) , Microsoft (MSFT - Free Report) , and Amazon (AMZN - Free Report) continue to lead the market.
Because I didn’t see a market “crash” on the horizon and believed we were deeply in the lower third of the correction alreadywhere institutional investors (other than Morgan Stanley) would be aggressively buying the S&P 500 under 2700.
One of our favorite vehicles to quickly and economically “grab that fear and buy it” is the opposite of SQQQ, the ProShares UltraPro QQQ 3X Bull ETF (TQQQ - Free Report) .
Since I believe the market is close to a bottom, getting long growth is still the way to play a classic Q4 rally.
Be sure to watch the video to learn more about how large investors are using Equity Risk Premium on a longer-term basis as the 2019 rates of growth for the economy and earnings get called into question.
Kevin Cook is a Senior Stock Strategist for Zacks Investment Research where he runs the TAZR Trader service.
Looking for Stocks with Skyrocketing Upside?
Zacks has just released a Special Report on the booming investment opportunities of legal marijuana.
Ignited by new referendums and legislation, this industry is expected to blast from an already robust $6.7 billion to $20.2 billion in 2021. Early investors stand to make a killing, but you have to be ready to act and know just where to look.
Image: Bigstock
Equity Risk Premium and Buying the Correction
Like most stock market corrections that come out of nowhere, they don't take their time inflicting the damage.
The express elevator going down to maximum pain only stops at a few floors to let well-prepared investors off.
The rest are found selling in a panic near the bottom. This October correction has been no different and now it's time to sift through the wreckage and see if it's safe to buy yet.
In the video that accompanies this article, I take a look at 3 of my favorite indicators for signaling extremes in pessimism that usually mark a near-term capitulation.
The 3 indicators are...
The S&P 500 Percent of Stocks Above Their 200-Day
The Total Put-Call Ratio
The S&P 1500 New Highs-New Lows Percent Index
I look at 5-year charts of all three so you can see a good comparison to prior peaks of pessimism, especially those during the sideways markets of 2015-16 where we went through a six-quarter earnings recession.
I also explain the quantitative logic of institutional investors who use some variation of the Equity Risk Premium (ERP) model to value equities as interest rates rise and growth slows from its torrid pace.
Macro Angst and the ERP Solution
So let's talk about what has some investors getting "less bold" about the late-cycle bull market -- and thus less apt to buy this correction aggressively -- as if the top is in and we go sideways for 6-12 months (just like 2015-16) unless/until earnings stage another surge.
First, let's look at EPS growth projections. This is an update of Sheraz's chart I've been showing you all year as it implies "peak growth" and "as good as it gets" conclusions...
The "half glass" debate investors will continue to have is whether we focus on 2019 still offering y-o-y growth on top of "impossible" comparables from Q1 and Q2 2018 (half full) or we focus on steep declines in the rate of growth that could be foreshadowing a boom gone bust (half empty).
Those bears at Morgan Stanley, led by chief investment officer Mike Wilson, are definitely still focused on half empty. That's what I talked about on TDAmeritrade-TV on Tuesday using this table which I will explain in detail...
Recall that Equity Risk Premium is a measure of how much extra investors want to be paid over the risk-free rate. For example, if the 10-year bond is at 3%, investors may want to be paid double that -- 600 basis points, or 6% -- another 300 basis points more to justify owning equities.
The way that you calculate and use this data involves only a few simple steps...
1) First, flip the P/E of the S&P 500 into its "earnings yield" so you have an apples-to-apples basis against the bond. This table uses the consensus estimate for 2019 of $174 EPS. At S&P 2800, that's a P/E of 16X. Flipped into its earnings yield, we get 174/2800 = 0.062, or 6.2%.
2) 6.2% sounds like a great return from stocks. Alas, intelligent investors subtract the risk-free rate so they know how much better they are actually doing for taking all the extra risk of stocks. 6.2% minus 3% (assumed 10-yr yield) leaves 320 basis points.
3) Using the right side of the Morgan Stanley table, we can assume how different institutional investors who have a choice of various ERPs (equity risk premiums) might think and allocate. If an investor wants only 300 basis points premium over the 3% risk-free rate, then he calls S&P 2906 "fair value" and would be a buyer below there.
4) What if we have a conservative investor who wants 350 basis points of premium over a projected 3.25% 10-year? Now you are talking 675 basis points. Back that into our equation and you get a much lower S&P: 174/.0675 = 2578 (roughly in line with their 2583 in table).
As you can read at the bottom of the tables, Morgan Stanley strategists believe the S&P 500 will be stuck in this 2,600 to 2,900 range for a while as the 10-year ranges 3-3.25% and investors want 300-350 bps cushion.
Which is really this "code" for their hedge fund clients: "We are probably going to S&P 2500, where we will gladly buy it. But not here, not now."
Gaming the Correction, Ignoring the Crash Theories
I put this analysis together last week and presented it on TD-Ameritrade TV on October 16, a day when the S&P 500 had a big rally back above 2800.
And I convinced myself that Mike Wilson and his team were really on to something about the new risks in this market with "peak growth" ideas and EPS estimates too high at $174.
So, on October 19, I set a minimum correction target for the Nasdaq 100 (NDX) to fill the May 7 gap at 6770. My worst-case scenario was just under 6600. To capture that move, on Monday we bought the ProShares UltraPro Short QQQ 3X Bear ETF (SQQQ - Free Report) when the NDX was around 7150.
On Wednesday the 24th, the NDX dropped to 6777, about a 5% downdraft which handed us 15% open gains in SQQQ. But those gains are hard to capture unless you grab them on the big days where the market closes red. That's why targets and plans are so vital.
I also told my followers it's safe to buy down there as long as Apple (AAPL - Free Report) , Microsoft (MSFT - Free Report) , and Amazon (AMZN - Free Report) continue to lead the market.
Because I didn’t see a market “crash” on the horizon and believed we were deeply in the lower third of the correction alreadywhere institutional investors (other than Morgan Stanley) would be aggressively buying the S&P 500 under 2700.
One of our favorite vehicles to quickly and economically “grab that fear and buy it” is the opposite of SQQQ, the ProShares UltraPro QQQ 3X Bull ETF (TQQQ - Free Report) .
Since I believe the market is close to a bottom, getting long growth is still the way to play a classic Q4 rally.
Be sure to watch the video to learn more about how large investors are using Equity Risk Premium on a longer-term basis as the 2019 rates of growth for the economy and earnings get called into question.
Kevin Cook is a Senior Stock Strategist for Zacks Investment Research where he runs the TAZR Trader service.
Looking for Stocks with Skyrocketing Upside?
Zacks has just released a Special Report on the booming investment opportunities of legal marijuana.
Ignited by new referendums and legislation, this industry is expected to blast from an already robust $6.7 billion to $20.2 billion in 2021. Early investors stand to make a killing, but you have to be ready to act and know just where to look.
See the pot trades we're targeting>>