Yesterday was the first time in a long, long time that the popular equity averages fell by 1% or more. The S&P 500 was down about 1.45%, the Dow Jones Industrial Average was down 0.93% and the NASDAQ 100 was down a whopping 2.2%. Such market action leaves us with a few questions. What caused investors to turn from buyers to sellers? Is this a one-day event or is this the start of something new?
Readers of TOE know we have been looking for a correction, but in the case of the S&P 500 or the NASDAQ 100, prices moved higher. The Russell 200 on the other hand barely budged. It has gone nowhere since the beginning of the year. A “thinning” of a rally where the large cap stocks move higher but the mid and small cap stocks lag is a sign that the rally underway is in its later stages. So why now? We could point at the usual suspects such as valuation and earnings, but what was different on Thursday from Monday this week. The only issues we can see is the North Korea issue. The dictator Kim Jung-un has been saber rattling quite a bit lately. To what end, we do not know. The North Korean government often acts badly so they can get economic assistance if they promise to play nice. But it is not working this time. The UN Security Council voted unanimously for economic sanctions, with the hopes the dictator will turn down his rhetoric and bring a halt to their nuclear program. The US President had
We could point at the usual suspects such as valuation and earnings, but what was different on Thursday from Monday this week. The only issues we can see is the North Korea issue. The dictator Kim Jung-un has been saber rattling quite a bit lately. To what end, we do not know. The North Korean government often acts badly so they can get economic assistance if they promise to play nice. But it is not working this time. The UN Security Council voted unanimously for economic sanctions, with the hopes the dictator will turn down his rhetoric and bring a halt to their nuclear program. The US President had harsh words for the dictator as well.
Things like this do not matter until they do. Investors have not cared about the verbal harpoons thrown back and forth between the DPRK and the West, particularly the US. We can only assume that investors are taking the situation more seriously. We, however, discount the severity of the situation. We do not think the “Dear Leader” of the DPRK will do anything other than throw temper tantrums. North Korea is a third world country with no hopes of development so long as the communist dictatorship is in place. The country is heavily armed to be sure. But those are conventional short range weapons that would inflict great harm South Korea. While they can wage a battle, they cannot wage a war against the world. If he starts a war, Kim Jung-un would find his time on this planet limited, and that is the last thing he wants. What he does want is to stay in power so he can live in luxury. In the final analysis, we do the DPRK will strike with a nuclear weapon or any other weapon for that matter.
There seems to be a change in sentiment, however. Nvidia’s earnings report was terrific. Revenues were up 56% year over year to $2.2 billion and GAAP EPS was up 124% to 0.92. Guidance was good calling for an 18% increase in sales year over year in the 3rd quarter. The company’s super fast microprocessors are key to the virtual reality, artificial intelligence and cryptocurrency market, so the long-term future looks bright for the company. Instead of celebrating this result, the stock fell 4.3% yesterday and it is down again in premarket trading today. It is this kind of reaction (selling on good news) is a sign of a selloff that might have some legs. So from this perspective, it is time for investors to lighten up on the risk exposure and sell or hedge exposures that they are uncomfortable with holding.
The of the S&P 500 above shows that the trend in higher prices that started at the beginning of the year is still intact. We are watching price action closely to see if the trend line breaks or provides support to prices. There are only a few points before the market is put the test. If the S&P 500 breaks below the 2,425 to 2,430 area, we think the odds of a decent size correction ( one that lasts for a few months time) increase substantially. We have suggested investors carry a light hedge in their portfolios to take the sting off a correction without giving away too much upside. Back in June, we suggested investors sell call spreads on IWM expiring this month. Since we do not know the composition of our subscriber’s portfolios, we left the size of the position to our reader’s discretion. If prices continue to fall, we think investors should consider initiating another hedge and maybe even upping the weight. We need to see more market action to get additional clarity to determine the best course of action going forward. Until then, stay on your toes.