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Are We There Yet?

Jeff Miller

Are we there yet? That's the question many investors are asking themselves after the recent declines in global stock markets. Year to date through February 3, 2014, the Dow is off 7.3%, the S&P 500 Index is down 5.8%, and the Nasdaq Index has declined 4.3%. And that is the good news. Overseas markets have been even worse, particularly in Asia. The Japanese Nikkei Index is down 9.5%, and many other markets in Asia have fallen more than 6%.

There are a few factors at work, but most of them share a common theme—emerging markets overall, especially China. On a stock-by-stock basis, U.S. companies got hammered if they reported strong earnings but weak sales in China, no matter how small or insignificant revenues or earnings from China were. On the other hand, companies that reported okay sales in China did well.

Why is China so important? Part of the reason for this pattern is China's purchasing power. The market's fear is that if China slows, Chinese demand for our higher-margin consumer and industrial goods will decline at the same time U.S. consumer spending growth is also slowing. In addition, a slowing China means lower demand for commodities and raw materials—the sales of which provide much of the hard currency for governments in many emerging markets.

To make matters worse for those emerging markets, the beginning of the end of quantitative easing in the U.S. makes U.S. assets relatively more attractive than the alternatives in many emerging markets. Ultra-low interest rates in the U.S. were intended to stimulate investment in manufacturing and jobs—and it worked, just not in the United States. That cheap money was invested in emerging markets. Now, the prospect of higher U.S. interest rates has made U.S. investments more attractive at the same time emerging markets have become oversaturated in investment dollars from abroad. As cheap liquidity returns home to the U.S., the traditional cycle of boom and bust is shifting once again to bust in emerging markets.

It's not just a slowing China that's causing the selloff. To some extent, China is just throwing gas on the fire. A confluence of events are hitting the markets all at once. Emerging markets such as Turkey, Indonesia, Argentina, Brazil and South Africa are all contributing to market anxiety through political unrest or anti-capitalist government policies. Investors tend to avoid political situations as "uninvestable" (read: we don't know what is going on, so we're out of here).

Friday's U.S. non-farm payroll number was much weaker than expected, while yesterday's ISM Manufacturing Index came in at a very weak 51.3 versus a prior 57 and expectations of 56. (Levels below 50 indicate contraction.) New orders also declined significantly from 64.4 to 51.1, while inventories fell 3 percentage points. Overall, this was an ugly release. Moreover, a number of high-profile U.S. consumer companies reported weaker-than-expected sales last week. This disappointing news, combined with generally weak retail sales overall, led to fears of a retreating consumer. And so the market continues to sell off.

Markets go up and markets go down—the cycles haven't changed much in 400 years. But the key to successfully navigating the markets is to know what game you are playing. "Play the game in front of you" is one of the Calamos Value Team's trading rules. So, it helps to know what kind of selloff the markets are in. Normally, the market's ebbs and flows are driven by buyers and sellers reacting to news on companies, changing industry prospects, or prospective interest rate changes. Usually, if the S&P 500 Index breaks meaningfully below its lower Bollinger Band on a daily chart, the market bounces in a day or so. (The Bollinger Bands measure recent market movements and generate two standard deviation bands above and below the recent price range.) The reason is simple: It's unusual for a whole market to stay two standard deviations below its recent range without dip buyers and bargain hunters showing up. We do it, and so do lots of other value buyers and traders.

Since this current decline isn't a "normal" selloff, I decided to look into the macro-driven selloffs in the recent past (1997, 1998, 2008, and 2011) to see if our team's sentiment and oversold indicators (i.e., the things that work in a regular day in and day out market) work in a macro semi-panic. They don't. The U.S. stock market has been oversold on a short-term basis since January 24, 2014, when the S&P 500 Index closed at 1790. Yesterday, it closed at 1742, or nearly 3% lower.

However, my work shows that in the U.S., the initial phase of these types of selloffs lasts for seven to 10 days before stabilizing (another leg lower is possible, but usually the market bounces first), and yesterday was day seven. Volume hasn't spiked to the levels that normally indicate a capitulation, so we could see some more selling in the next few days. Dip buyers will wait for "clarity" (meaning they don't want to lose their fingers trying to catch a falling knife). When you get into a macro driven selloff like this, there are factors at work beyond "this stock is cheap or expensive." You get forced sellers, people that are levered and wrong and hitting stop losses or margin calls, or those that have to sell because of redemptions. It's these forced sellers, those that have no choice but to sell, that are in charge at this stage of a selloff.

Raghuram Rajan, the head of the Reserve Bank of India, summed up what is going on in the markets particularly well. (He spotted the 2008 financial crisis early, in 2005.) This weekend, John Mauldin's Thoughts From the Frontline quoted him in "Central Banker Throwdown." Speaking about the last week's currency market turmoil, Rajan said,

"Fortunately, I think we've had a few months in India to prepare, given that first inkling that there would be this withdrawal of the money, given the wave of attack we saw in terms of money flowing out. I think we are much better prepared now, but I would still say international monetary cooperation has broken down. ...

"You see, the nostrum amongst economists here is 'Let the prices adjust and things will be fine. Let the exchange rate move; let the money flow out; and you will figure it out.' That is often a reasonable prescription for an economy that has its fundamentals, as well as its institutions, well-anchored. But when that's not the case, volatility feeds on itself. Exchange rates fall. Stop loss limits are hit. More selling takes place. Then some firms get into difficulty because they have unhedged exposures. Government budgets get hit because they're not hedged against currency fluctuations. There are also second- and third-round effects which happen in a country which is not as advanced or industrialized."

U.S. investors aren't driving the bus. Currency traders are, and that is a huge market. We'll have to buckle our seat belts and ride this one out, while using this weakness to buy stocks of companies we like. Again.

Past performance is no guarantee of future results. The S&P 500 Index is considered generally representative of the U.S. equity market. The Nasdaq Index tracks the securities listed on the NASDAQ exchange and is viewed as a benchmark of technology and smaller cap stock performance. The Dow Jones Industrial Average includes 30 bellwether U.S. companies. The Nikkei Index tracks the performance of the Tokyo Stock Exchange. Indexes and averages are unmanaged, do not include fees and expenses and are not available for direct investment.

The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.

The information in this report should not be considered a recommendation to purchase or sell any particular security. The views and strategies described may not be suitable for all investors.

As a result of political or economic instability in foreign countries, there can be special risks associated with investing in foreign securities, including fluctuations in currency exchange rates, increased price volatility and difficulty obtaining information. In addition, emerging markets may present additional risk due to potential for greater economic and political instability in less developed countries.

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