Stock Drops Aren't Easy, but This Week’s Were Expected

The market’s current bottoming process is playing out according to textbook, says Andrew Adams, CFA, CMT, Senior Research Associate.

November 14, 2018

It’s never fun to watch the stock market fall (unless you happen to be a short seller), but the weakness over the past few sessions hasn’t been too concerning since it was “supposed” to happen. The market got scary in October because it exceeded expectations for what we’d experience on the downside, but – so far, at least – the bottoming process off of the October 29 low in the S&P 500 is playing out according to textbook.

Two weeks ago, I expected any bounce attempt to eventually stall out about where the S&P 500 ran into trouble during its mid-October throwback rally. The index ended up slightly exceeding that level before dropping once more, but it was close enough for me to still have confidence in the way it was playing out. The rally off the following low ended up being a quick 8% move higher in just over a week – a pace that wasn’t sustainable even if the stock market did mark a major low at the end of October. Therefore, the weakness that’s followed is not a surprise and is consistent with the bottoming process that remains our base case scenario.

The upward jump made by the S&P 500 (and many other indices and stocks) on October 31 looms large, and the odds still favor seeing continued weakness that ultimately fills that gap, bringing us back to pre-October 31 levels. The stock market rarely trades exactly how you think it should, but a drop down to about 2685 that is met with strong buying demand would be about the best bottoming sequence possible. And with expectations for the future remaining depressed based on the evidence I see, I think the market would be set up quite nicely to surprise to the upside if it plays out that way.

Of course, anything can happen, and we will adjust if things develop in a way that diverges from our expectations. As of now, I am still proceeding as if the lows have been made until I am given a good enough reason to believe otherwise. One major reason I continue to have confidence that this remains a bottoming process is that even when I take a peek under the surface of the market, most areas remain above their recent respective lows. Oftentimes, we see strength in major averages like the S&P 500 though other areas continue to show weakness (e.g. small caps, international stocks, semiconductors, biotechnology, etc.). However, I am not currently seeing the red flags that would be raised if groups such as these broke down through their recent lows.

The same goes for breadth and momentum readings, which indicate that selling has not been as pronounced across the board over the last few sessions. If this pattern continues, it could mean that major bottoms have formed across the global market, further supporting an upside surprise. I am not really seeing many attractive individual setups yet, which is a bit concerning, but that could change with another round of strength here shortly.

As funny as it may sound, I am actually more worried about what happens if the market takes off again before returning to pre-October 31 levels. Gaps do not have to be filled, of course, but leaving it unfilled would force me to be a little more skeptical of any subsequent rally, since the question would remain if we’d drop back down to fill it at some point in the future. Since the indices are already close to those gap levels, they might as well fill them so we can move on.

All expressions of opinion reflect the judgment of Raymond James & Associates, Inc., and are subject to change. There is no assurance any of the trends mentioned will continue or that any of the forecasts mentioned will occur. Economic and market conditions are subject to change. Investing involves risk including the possible loss of capital. International investing involves additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets. Companies engaged in business related to a specific sector are subject to fierce competition and their products and services may be subject to rapid obsolescence. Investing in small- and mid-cap stocks generally involves greater risks, and therefore, may not be appropriate for every investor. The S&P 500 is an unmanaged index of 500 widely held stocks. It is not possible to invest directly in an index Past performance may not be indicative of future results.