For weeks the talking heads on financial news channels have been saying that the stock market was overdue for a correction. I’m not sure what that really means. It is easy to tell when my dog is overdue for a bath because he stinks. It is more challenging to know when stocks are going to correct.  There is no standard formula that says a rally can only last eight months or can only climb 15% before a serious pullback. Nevertheless, all the recent talk about a coming correction certainly had investors on edge.

When news of China’s market meltdown reached U.S. traders Tuesday, many were already looking for a reason to stampede to the exit.

I experienced a similar situation a couple of weeks ago. My wife and I went to the cinema and she reluctantly agreed to watch a scary movie. There were lots of young people in attendance–specifically teenage girls. To build suspense, the movie had ominous music and on screen cues meant to mislead the audience. Several times everyone was convinced that a scary scene was coming even though it did not. In each case, all the young girls would scream in anticipation.

My wife was doing quite well with the movie, but the audience screams convinced her that when something bad eventually did occur, it was going to be horrific. Whether that is true or not I will never know. The anticipation became too much for her to bear and we had to leave before the movie even got to the really scary part.

I think market activity and commentary over the past few weeks had pushed many investors to an emotional brink. The decline in the Chinese market was the event that forced them over the edge.

The chart below shows the daily price activity for the S&P 500 (black line) over the past year. The blue line is a simple 50-day moving average. (The gold line is the Nasdaq, included just for comparison). Notice that the S&P trended above its 50-day MA since July. Over the past couple of months it approached the blue line a couple of times, but in recent sessions it again traded well above that level. With Tuesday’s 5% decline, it broke well below that support level in a single session.

The same can be seen on the bottom portions of the chart. The moving average convergence divergence (MACD) and the relative strength index (RSI) both went from positive to negative in a single day.

I could expend quite a bit of time and effort explaining why the Chinese market sold off and the ensuring impact on U.S. stocks. But in fact there is no fundamental or technical economic change between Monday and Tuesday that should have caused a correction of this magnitude. This move was driven by investor emotion and not by economic or market fundamentals. Although there are some indicators that attempt to measure investor sentiment, I know of none that can accurately gauge the two major investor emotions: fear and greed.

The real question now becomes: how should one react to this event? Will stocks continue to slide or will this be the bottom?

While it is hard to say for certain, it seems likely that the worst of the damage is done. In the most serious correction since 2002, last spring we saw the S&P 500 drop about 7%. That downturn took several weeks to unravel. After Tuesday’s sharp move, stocks will need to build a news base and re-establish support. During that process we could see major indices drop another percent or two.

As long as that is the type of action we see, the best course from here is probably to hang on and ride it out. But if we see another major decline like we saw on Tuesday then all bets are off and the safest action will probably be to move to cash until the situation stabilizes.

F.S.

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