From Overbought to Oversold — Stocks Set for Rebound

Global stock markets have suffered a fierce selloff to begin 2014. In fact, last month was the worst January performance since the bull market began five years ago.

Such weakness in equities early in the New Year is unusual since January is traditionally a very bullish month for capital flows into financial markets, especially stocks.

Pension plans, retirement accounts and mutual funds typically receive a big influx of fresh cash at year-end, or early in the New Year, which must be invested. Professional money managers put all these dollars to work or risk having their performance lag the S&P 500 Index.

That is why January has historically been one of the best months to be invested in stocks. Since 1928, the S&P 500 has gained 1.25 percent, on average, during January. But not this year, and that’s a caution flag for investors.

As I pointed out last week in Money and Markets, the path stocks take in January correctly predicts the full-year market trend 81.6 percent of the time, according to data from the Stock Trader’s Almanac.

Utilities bucked the market and started the year strong.

When January is up, the S&P 500 has posted favorable full-year gains of 13 percent, on average.

But when January is down, the stock market’s average annual return falls to negative 2.3 percent.

It’s worth remembering, however, that these historical patterns don’t always follow the script. In 2009, for example, the stock market plunged 8.6 percent in January, yet the S&P 500 still finished 23.5 percent higher by year-end.

As I said last week: “Stocks were overbought to start the year,” and in need of a healthy correction. Including the follow-on selling we witnessed early this week as February began, it’s safe to say the correction has arrived, with stocks down nearly 6 percent from the high.

But is this sell-off a buying opportunity?

There is no question the selling has been intense and compressed into a short time frame. After all, it was just a few weeks ago, Jan. 15 to be exact, when the S&P 500 was above 1,850.

This past Monday alone, the S&P 500 plunged 2.3 percent, the biggest single-day decline since June, to close at 1,741. In fact, Monday’s heavy selling was accompanied by the second of two 90 percent down days in less than two weeks.

A 90 percent down day occurs when 90 percent or more of all stocks on the NYSE decline in price and 90 percent or more of total trading volume is also to the downside.

On Monday, 95.5 percent of stocks declined with 94.2 percent downside volume.

Such extreme selling indicates capitulation by investors who are throwing in the towel. It’s a sign of a market washout when everyone who wants to sell has done so, and a short-term rally typically follows.

In fact, looking at recent market history, since 2006 whenever stocks get this oversold, the S&P 500 rallies an average of 4 percent over the next two months and the market is up 68.6 percent of the time.

Another good question is: Which markets, sectors or stocks might provide the best buying opportunities for a rebound rally?

I suggest you look at the best-performing stocks and ETFs last month. In other words, spend some time researching investments that bucked the market’s January down trend with strong relative price strength. That’s where to start your homework.

For instance, only three industry groups posted positive returns in January:

* Real estate investment trusts (REITs), up 2.9 percent last month

* Utilities, which also gained 2.9 percent

* Pharmaceutical and Biotechnology stocks, up 1.3 percent

Many investors point to rising interest rates caused by Fed tapering as a key reason for the stock market decline. But if that were true, why would two of the most interest-rate-sensitive sectors be the top performers last month?

Another excuse for the correction is turmoil in emerging markets. But when you take a closer look at the best-performing global stock markets last month, nearly all of them are emerging markets, including:

* Dubai, up 11.9 percent

* Vietnam, up 10.5 percent

* Bulgaria, up 9 percent

* Egypt, which has been rocked with violent political protests, is up 8.9 percent

The list of top-performing stock markets this year also includes Pakistan, Sri Lanka, Indonesia and Venezuela — these are not exactly models for stable investment returns.

In fact, Denmark is the only developed country that even cracks the top 20 in performance, with a gain of 3.2 percent.

If this were just the beginning of a steeper and prolonged market decline, fueled by interest rates spiraling higher and economic collapse in the emerging world, you would not expect to see utilities, REITs and emerging market stocks among your top-performing investments year — far from it.

Bottom line: Stocks started 2014 in overbought territory but have quickly become oversold and are likely to rally in the months ahead.

Good investing,

Mike Burnick

Mike Burnick, with 30 years of professional investment experience, is the Executive Director for The Edelson Institute, where he is the editor of Real Wealth Report, Gold Mining Millionaire, and E-Wave Trader. Mike has been a Registered Investment Adviser and portfolio manager responsible for the day-to-day operations of a mutual fund. He also served as Director of Research for Weiss Capital Management, where he assisted with trading and asset-allocation responsibilities for a $5 million ETF portfolio.