Investors looking for a V-shaped, "buy-the-dip" market recovery were sorely disappointed last week as the major indices took another tumble.
The Dow Jones Industrial Average lost another 541 points or 3.2% to close at 16,102.38 while the S&P 500 dropped 68 points or 3.4% to 1921.22. The Dow is now solidly in 10% correction territory from its 18,351.40 closing high earlier this year and down 9.7% year to date.
The S&P 500 is down 9.8% from its 2,134.72 closing high in May and down 6.7% year to date.
The Nasdaq Composite Index also fell 3%, or 144 points, to end the week at 4,683.22, also in 10% correction territory from its all-time closing high earlier this year of 5,231.94 and down 1.1% year to date.
This was the second worst week of the year for U.S. stocks, topped only by the 5% drop two weeks earlier.
As you'll see, we have every reason to expect this slaughter to continue, but there are some very compelling plays for upside here for us…
The Pundits Can't Just Talk Up a Rally
The reasons for the market decline are numerous: fears that the Fed will actually raise rates at its next meeting in a couple of weeks (which would be a good thing); increasing acknowledgement that China's economy is not only a mess but a mess that won't be fixed anytime soon; and continued weakness in commodity prices.
But do not despair – none of this is deterring Wall Street "strategists." In a new Barron's survey, Wall Street strategists (an oxymoron in and of itself) called for the S&P 500 to rally by 10% to 2150 by year-end.
Maybe they'll be right and maybe they'll be wrong, but the one thing that can be said about these so-called experts who are never bearish is that they are never in doubt and never short of reasons why markets should grow to the sky.
Why Barron's even bothers to publish their predictions and why anyone would take them seriously is beyond me, but these clueless folks are best regarded as the pundits who try to pick the Super Bowl winner at the beginning of each NFL season.
All readers of this publication need to know is that, with few exceptions, the people hawking their views in the media should be ignored. Just like a judge is a lawyer who knows a politician, a television market pundit is a stock-jockey who knows a television producer. Beyond that and his or her good looks, he or she has no special insights into markets.
I Don't See Much "Attractive Value" Here
Now that stocks have corrected, everyone is asking if they are again attractively valued.
Unfortunately, the answer is no.
Stocks are still trading at price/earnings multiples that are considerably higher than historical averages. Current U.S. price/earnings ratios are at the top end of their 10-year range.
While other measures such as the S&P 500 Market Cap/GDP Ratio and the Schiller Cyclically Adjusted P/E Ratio have dropped slightly from record highs, they are still well above historical averages as well.
And certain sectors of the market, such as social media and biotech stocks, are still grossly overvalued. When stocks like Tesla Motors Inc. (Nasdaq: TSLA) and Amazon.com Inc. (Nasdaq: AMZN) drop by 25% to 50%, we will know that the bubble has burst. Interestingly enough, one of the most overvalued stocks in the market, Netflix Inc. (Nasdaq: NFLX), has sold off by about 25% from its recent high. Netflix is an exception – other highly valued stocks that have driven the market higher have yet to give up the ghost. But they will.
Heading into the correction, valuations were at extremes. Investors were brainwashed into thinking that they had to buy stocks because bonds had been turned into certificates of confiscation by global central banks.
The consensus told them that economic growth was healthy and interest rates would increase. They are now coming to terms with the fact that this was hogwash.
Economic growth is slowing around the world and while the Fed may raise rates, European, Japanese and Chinese central banks are doubling down on lowering interest rates and QE policies. This means that global interest rates will remain low.
It also means that the most important financial instrument in the world – the U.S. dollar – will remain strong. And a strong dollar will continue to keep a lid on commodity prices – including oil. Oil experienced a short-covering and technical rally during the last week of August that quickly faded.
Here's What We Should Do
As long as the dollar remains in an uptrend, commodity prices and oil prices in particular will remain under pressure.
The U.S. Dollar Index, which is 70% comprised of the euro and the yen, closed the week at 96.22. The key level to watch on the DXY is 98 – if it breaks through 98, the dollar is likely to rally significantly further.
With the euro trading at $1.1147 and the yen at 118.95, both currencies have considerable room to decline. With their central banks telling the world they will keep printing money until their printing presses break down, it is a good bet that their currencies will see further lows before the end of the year.
That will push the dollar higher and keep pressure on commodities and U.S. stocks in the months ahead. Investors who want to take advantage of this should buy PowerShares DB U.S. Dollar Index Bullish ETF (NYSE Arca: UUP).
Investors have been conditioned to "buy the dips" during the bull market of the last six years.
This dip, however, is different than previous ones. They should be very wary of trying to catch this falling anvil of a market until there are signs of stabilization on the horizon.
In the meantime, they should reduce or hedge their stock positions. The easiest way to hedge is to buy ProShares Short S&P 500 ETF (NYSE Arca: SH), which will rise if stocks decline.
About the Author
Prominent money manager. Has built top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.