It is always a little frightening when the market starts a correction. In the back of an investor’s mind he is always wondering if this is the start of the next big bear market. Truthfully, no one knows. But in the case of this current three-day downturn, this seems like just normal corrective activity. After today’s downturn, the major indices were each off slightly less than 3% and have given up about three weeks of recent gains.

The prior downturn in February was steeper and even more worrisome. Take a look at the chart below to help keep things in perspective. What you are seeing is a one-year comparison of the Nasdaq (black line), the Dow (gold line) and the S&P 500 (blue line). The curved brown line is a 50-day moving average (MA) of the Nasdaq.

In the February drop, all three indices dropped below their 50-day MAs almost immediately. The entire correction lasted just over a week and three weeks later the indices were back above their 50-day MAs and and climbing steadily toward new highs. So far this decline is not as sharp, but it could persist longer, just because of the summer season. Trading volumes tend to be lower and traders and investors often liquidate or hedge long positions before going on vacation.

The two bottom sections of this chart show a moving average convergence divergence (MACD) and a relative strength index for the Nasdaq. Both are currently resting on levels that indicate that stocks could go either way from this spot. The market’s direction over the next couple of days should give us a better idea of what lies ahead. A bounce from this level could quickly send major indices back to new highs in a couple of weeks. But more downward action could end with stocks testing support another 3% or 4% below the current mark.

Today’s continued slide was primarily attributed to the fact that 10-year bond yields climbed above 5%. But that number is really only psychologically significant. Most investors are not going to turn from stocks to bonds just because the yield exceeded 5%. What will eventually drive investors to choose bonds over stocks is a weak economy. And in spite of much weaker GDP growth in the first quarter of this year, there are still plenty of indications that the economy is far from falling into a recession.

In fact, those signs of economic strength are actually hurting stocks right now because Wall Street realizes that Federal Reserve officials can point to plenty of reasons for avoiding a decrease in interest rates. The indicators of a solid economy remain the same as for the past several months: unemployment remains very low, inflation seems to be under control, consumer spending is still strong, corporate earnings are very good, and interest rates are still low by historical standards.

Even the financial markets remain healthy in spite of the latest downturn. The long-term trend is still up for stocks and there are many sectors that are doing very well.

To get an idea of how well the market sectors are faring, let’s take a look at the 136 iShares exchange-traded funds (ETFs) that cover almost every sector or index one can think of. For the 30 days prior to June 5, 101 of those funds had positive returns. Over the prior three months, only 12 funds had negative returns and they all represented bond indexes. For the prior six months only 14 have had negative returns and they were all funds representing real estate or bond indexes.

International funds continue to outperform the U.S. markets in general. Here are the returns of the top 25 iShares funds over the past 30 days. The list is dominated by international and energy or natural resource funds.

For now the wisest action for investors would appear to be to hold the course. As long as the long-term trend remains intact, corrections like this one should prove to be nothing more serious than a normal bump in the road.
F.S.